What is an option spread?

An option spread is defined as the simultaneous purchase of one option and the sale of another option of the same class. This strategy involves taking a position on the same underlying asset, but with different strike prices or expiration dates, resulting in a strategic approach to managing risk and potential profits.

By buying one option and selling another, traders can limit their maximum loss while potentially benefiting from a narrower price movement in the underlying asset. This allows for various trading strategies, such as bullish spreads (where the expectation is that the underlying will rise) and bearish spreads (where the expectation is that the underlying will fall).

Spreads can also be categorized into different types based on the options involved, such as vertical spreads (which involve options of the same class with different strike prices), horizontal spreads (which involve different expiration dates), and diagonal spreads (which combine both differences in strike prices and expiration dates). Understanding how spreads function is crucial for traders, as these strategies can enhance trading effectiveness while managing risk.