Naming spreads | Advanced strategies | Strategies

Options terminology is similar to 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 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.

Sidenote

Complex spread strategies

Although most spreads involve two legs (e.g., one long call and one short call), more advanced spread strategies exist. For example, a butterfly spread involves three spreads and four options. Here’s what it can look like:

Long 1 ABC Jan 30 call
Short 2 ABC Jan 40 calls
Long 1 ABC Jan 50 call

As the name suggests, this strategy involves a solid “core” (the two short calls) with “wings” on either side (the long 30 call and the long 50 call). We’ll discuss these strategies in a future chapter.

Definitions

Leg (options): A single option position
Multi-leg strategy (options): A strategy involving two or more option types

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).

Definitions

Debit: Represents money paid to buy an option; associated with going long an option
Credit: Represents money received to sell an option; associated with going short an option

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?

(spoiler)

The short put has the highest premium, making it the dominant leg. The names associated with this strategy are:

Short put spread
Bull put spread
Credit put spread

It’s a ‘short put spread’ because the short put is the dominant leg. It’s a ‘bull put spread’ because the dominant leg is bullish. It’s a ‘credit put spread’ because the short put is more expensive, creating a net credit (net sale).

The strike prices

If you’re not provided premiums and encounter a vertical (price) spread, you can rely on the strike prices to identify 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?

(spoiler)

The short call has the lowest strike price, making it the dominant leg. The names associated with this strategy are:

Short call spread
Bear call spread
Credit call spread

It’s a ‘short call spread’ because the short call is the dominant leg. It’s a ‘bear call spread’ because the dominant leg is bearish. 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?

(spoiler)

The long put has the highest strike price, making it the dominant leg. The names associated with this strategy are:

Long put spread
Bear put spread
Debit put spread

It’s a ‘long put spread’ because the long put is the dominant leg. It’s a ‘bear put spread’ because the dominant leg is bearish. 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 a month earlier 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?

(spoiler)

The long call has the longest time to expiration, making it the dominant leg. The names associated with this strategy are:

Long call spread
Bull call spread
Debit call spread

It’s a ‘long call spread’ because the long call is the dominant leg. It’s a ‘bull call spread’ because the dominant leg is bullish. 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:

Key points

Naming spreads

The dominant leg names the spread

Identifying the dominant leg

Highest premium
Vertical call spreads: low strike price
Vertical put spreads: high strike price
Horizontal spreads: long expiration