Naming spreads
As we discussed in a previous chapter, options terminology is like a foreign language. You’ve already learned terms like long, short, “in the money,” “out of the money,” and intrinsic value. A new set of unique spread terms must also be known for the exam.
Although two or more legs make up a spread, there’s always a “dominant” option. Each contract influences the the strategy’s risk and return potential, but one is always more important than the other. Understanding this concept is important because the “dominant” option names the spread.
You’ll learn why one option is dominant when you reach the math-based spread sections in the next two chapters.
There are three specific ways to determine the dominant option within a spread:
- The option premiums
- The strike prices
- The expirations
Let’s go through each!
The option premiums
The dominant leg within a spread is also the most valuable contract. An option’s premium represents its market value - the more valuable the contract, the higher the premium. Therefore, the option with the highest premium is the dominant leg.
For example:
Long 1 ABC Jan 60 call @ $7
Short 1 ABC Jan 70 call @ $2
The long call maintains the highest premium, making it the dominant leg. Remember, the dominant leg names the spread! This spread has three names, all of which are synonymous (mean the same thing):
- Long call spread
- Bull call spread
- Debit call spread
Each name relates to the dominant long call leg. It’s a ‘long call spread’ because the long call is dominant. It’s a ‘bull call spread’ because the long call is bullish. It’s a ‘debit call spread’ because the long call is more expensive, creating a net debit (net purchase).
Let’s see if you can accurately name a spread.
An investor goes long 1 BCD Feb 25 put at $4 and short 1 BCD Feb 40 put at $11. What are the three names associated with this spread?
Can you figure it out?
The short put has the highest premium, making it the dominant leg. The names associated with this strategy are:
- Short put spread
It’s a ‘short put spread’ because the short put is the dominant leg.
- Bull put spread
It’s a ‘bull put spread’ because the dominant leg is bullish.
- Credit put spread
It’s a ‘credit put spread’ because the short put is more expensive, creating a net credit (net sale).
When the premium is provided, finding the dominant option is fairly simple. The option with the larger premium is always the dominant leg.
The strike prices
If you’re not provided premiums and encounter a vertical (price) spread, you can rely on the strike prices to find the dominant option. As a reminder, a vertical spread involves legs with different strike prices, but the same expiration. These are the two guidelines for identifying the dominant leg with this type of spread:
- Call spreads: low strike price
- Put spreads: high strike price
Even if the premium isn’t provided, the dominant option in a spread is still the more valuable leg. Exploring this idea further, call options with low strike prices are more valuable than those with high strike prices. Regardless of long or short status, a $20 call should be more expensive than a $30 call. The $20 call gives the holder the right to buy stock at $20, while the $30 call gives the holder the right to buy stock at $30. The right to buy at a lower price reflects a more valuable contract.
Let’s see if you can accurately name a price spread.
An investor goes short 1 MNO Jun 80 call and long 1 MNO Jun 95 call. What are the three names associated with this call spread?
The short call has the lowest strike price, making it the dominant leg. The names associated with this strategy are:
- Short call spread
It’s a ‘short call spread’ because the short call is the dominant leg.
- Bear call spread
It’s a ‘bear call spread’ because the dominant leg is bearish.
- Credit call spread
It’s a ‘credit call spread’ because the short call is more expensive, creating a net credit (net sale).
Let’s explore how it works with put spreads.
Put options with high strike prices are more valuable than those with low strike prices. Regardless of long or short status, a $50 put should be more expensive than a $40 put. The $50 put gives the holder the right to sell stock at $50, while the $40 put gives the holder the right to sell stock at $40. The right to sell at a higher price reflects a more valuable contract.
One more price spread example, this time with puts:
An investor goes short 1 RTR Dec 120 put and long 1 RTR Dec 140 put. What are the three names associated with this put spread?
The long put has the highest strike price, making it the dominant leg. The names associated with this strategy are:
- Long put spread
It’s a ‘long put spread’ because the long put is the dominant leg.
- Bear put spread
It’s a ‘bear put spread’ because the dominant leg is bearish.
- Debit put spread
It’s a ‘debit put spread’ because the long put is more expensive, creating a net debit (net purchase).
The expirations
If you’re not provided premiums and encounter a horizontal (calendar/time) spread, you can rely on the expirations to find the dominant option. As a reminder, a horizontal spread involves legs with different expirations, but the same strike price. The contract with the longer time to expiration is the dominant leg.
As we learned in a previous chapter, time value represents the value an option provides concerning time. The more time until the option expires, the more valuable the contract. For example, an option expiring in February is more valuable than an option expiring in January. The holder pays more for the extra time to exercise the option, and the seller receives more for obligating themselves for longer periods. Therefore, the contract with the longest time to expiration is the dominant leg.
Let’s take a look at an example:
An investor goes short 1 TM Sep 55 call and long 1 TM Oct 55 call. What are the three names associated with this call spread?
The long call has the longest time to expiration, making it the dominant leg. The names associated with this strategy are:
- Long call spread
It’s a ‘long call spread’ because the long call is the dominant leg.
- Bull call spread
It’s a ‘bull call spread’ because the dominant leg is bullish.
- Debit call spread
It’s a ‘debit call spread’ because the long call is more expensive, creating a net debit (net purchase).
This video covers the important concepts related to naming spreads:
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