7584 / What is a “spread” transaction?

Example: ILM corporation’s stock is trading at $91 in November, but Ms. Noel expects it to decline. She writes an ILM January 80 call and collects a premium of $1300 for it. Since she does not own ILM stock and does not wish to assume the risks of writing an uncovered call, Ms. Noel also buys an ILM January 90 call at a cost of $600. If the price of ILM drops to $79, Ms. Noel will have made a profit of $700 (the difference between the premium she paid and the premium she collected). If the price does not drop, she has limited her loss to $300 (the $1000 difference between the strike prices of the two options minus the $700 net
premium).

The three basic types of spreads are vertical (or price), horizontal (or time), and diagonal (combination of vertical and horizontal). Spreads are also (regardless of their type) referred to either as credit, debit, or even. In a debit spread, the costs of the long (purchased) position exceed the proceeds of the short (sold) position. In a credit spread, the proceeds of the short position exceed the cost of the long position. If the costs and proceeds are equal, the spread is even.

Vertical Spreads. A vertical spread (also referred to as a price, money, or perpendicular spread) is the simultaneous purchase and sale of puts or calls with the same underlying security and expiration date, but with different strike prices. An investment in a vertical spread is based upon the expectation that the option purchased is undervalued relative to the option sold.

Horizontal Spreads. A horizontal spread (also referred to as a time or calendar spread) is the simultaneous purchase and sale of puts or calls with the same underlying security and strike price, but with different expiration dates. Horizontal spreads are purchased in anticipation that over time the spread will widen.

Diagonal Spreads. A diagonal spread is a combination of a vertical spread and a horizontal spread; thus, it is the simultaneous purchase and sale of puts and calls with the same underlying security but with different strike prices and expiration dates.

Within each of the categories described above (vertical, horizontal, diagonal), a spread can also be characterized as a bull spread, bear spread, or butterfly spread. A bull spread is the combination of a long position at a lower strike price and a short position at a higher strike price. It is so named because it will generally be profitable if the underlying security goes up in value. In a bear spread the opposite is true: the strike price of the long position is higher than the strike price of the short position, and the investor will generally profit if the trading price of the underlying security goes down. A butterfly spread is a combination in which the investor holds three put or call positions in the same underlying security at three different strike prices. The expiration dates may be the same or the spread may be “diagonalized” by having different expiration dates.

Butterfly spreads are so named because the respective “sizes” of the positions invoke the image of a butterfly. The Tax Court has described butterfly spreads as follows: “The highest and lowest strike positions are one-half the size of the middle position, and the middle position (the body) is long (or short) and the highest and lowest positions (the wings) are short (or long). The highest and lowest positions are equidistant from the middle position.”²

See Q 7585 for an explanation of the tax treatment of spread transactions.