The combination of two different options strategies can often dramatically enhance the attractiveness of a trader’s risk-to-reward profile. One of the more basic type of combination strategies involve buying one option and selling another option on the same underlying stock. This type of combination is referred to as a spread.

The three basic building block spreads include vertical spreads, horizontal spreads, and diagonal spreads. Vertical spreads involve either two calls or two puts that are identical except for the strike prices. Horizontal spreads, also known as time spreads, include either two calls or two puts that are identical except for the expiration dates. Diagonal spreads are a combination of both the vertical and horizontal spreads.

The puts or calls used in a diagonal spread have different strike prices as well as different expirations. These spreads can reflect any type of market bias be it bullish, bearish, or neutral. The strategy’s bias is determined strictly by the investor’s choice of puts, calls, strike prices, and expiration dates.

A vertical spread is constructed by buying one option and selling another that is identical in every respect except for the strike price. Investors often use vertical spreads to attempt to profit from a correct stock price forecast. The long position and short position are designed to strike a balance between risk and reward. The result is as a hedged directional strategy where the profit opportunity is limited, but so is the risk.

A spread involves paying a premium for the long option and receiving a premium for the short option. A short spread strategy generates a net credit, whereas a long spread results in a net debit. In either case, should the investor’s forecasts turn out to be wrong, one contract mitigates the losses from the other. Also, the long position covers the assignment risk arising from the short option.

Depending on how the strike prices are selected, a vertical spread can be either bullish or bearish. A wider distance between the strike prices indicates a stronger opinion, and the amount by which the options are initially in-the-money or out-of-the-money usually measures how conservative or aggressive the spread is.

For a time spread the options strategist uses either two calls or two puts that are identical in all respects except for the expiration dates. Time spreads can be created to reflect a bullish, bearish, or neutral outlook. An example of a time spread would be buying a 6-month XYZ 50 call and selling a 1-month XYZ 50 call.

Generally, the main goal of writing the shorter term contract is to offset some of the cost of the long contract. In principle, the long position covers the assignment risk of the short position. The intention is that the short call will lose its time value very rapidly, making it cheaper to buy back and unlikely to be assigned. If it expires without being assigned, the investor keeps both the premium income and any subsequent appreciation on the long call.

Diagonal spreads are similar except they involve different strike prices. Putting together a diagonal spread involves selling a short-term option and buying a longer-term option with different strike prices. A diagonal spread can be bullish or bearish in bias.

A bullish diagonal spread uses a long call with a distant expiration and a lower strike price along with a short call with a closer expiration date and a higher strike price. A bearish diagonal spread combines a long put with a distant expiration date and a higher strike price along with a short put with a closer expiration date and a lower strike price.

Diagonal spreads are sensitive to changes in the stock price, volatility, and the time remaining until expiration. These pricing factors tend to affect the two options unequally, so it is difficult to make any judgments about their relative prices and therefore the strategy’s profitability.

This is why it is highly recommended that you have access to a powerful options analysis tool, such as the Optionetics Platinum package, to dynamically generate an accurate risk-to-reward profile. The software helps the trader quickly analyze and properly assess their risk exposure while at the same time maximizing their reward potential—two absolutely essential characteristics of a successful trading business.

Happy Trading.


Jeff Neal 
Senior Writer, Options Strategist & Profit Strategies Radio Show Market Correspondent
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