Last week we talked about some simple rules to make straddles more intuitive. Now let’s talk about the other option combo covered heavily on the Series 7: spreads.
Our pneumonic tells us that spreads are bets on price, hence “R” is in both. And we all know that calls and options are bets on price in one direction, so it’s unsurprising that the first rule of spreads is:
1. Spreads are long/short a combination of two calls or two puts.
They can differ in terms of price, in date, or in both. Remember what a simple matrix of ranges across domains looks like—this is the basis of options charts, too.
| Call Premium | Strike Price | Put Premium |
| $0.01 | 5 | $3.00 |
| $0.16 | 6 | $2.85 |
| $0.31 | 7 | $2.70 |
| $0.46 | 8 | $2.55 |
| $0.61 | 9 | $2.40 |
| $0.76 | 10 | $2.25 |
| $0.91 | 11 | $2.10 |
| $1.06 | 12 | $1.95 |
| $1.21 | 13 | $1.80 |
| $1.36 | 14 | $1.65 |
| $1.51 | 15 | $1.51 |
| $1.65 | 16 | $1.36 |
| $1.80 | 17 | $1.21 |
| $1.95 | 18 | $1.06 |
| $2.10 | 19 | $0.91 |
| $2.25 | 20 | $0.76 |
| $2.40 | 21 | $0.61 |
| $2.55 | 22 | $0.46 |
| $2.70 | 23 | $0.31 |
| $2.85 | 24 | $0.16 |
| $3.00 | 25 | $0.01 |
If we’re choosing two different prices, we’re going vertical along the chart. Time is typically displayed horizontally, so choosing two different dates is horizontal. Combined is obviously both, so diagonal. Now we have a second rule.
2. Spreads are horizontal (time changes), vertical (price changes), or diagonal (price/time changes)
Now, to start calculating max loss and max gain, we need to determine whether we’re dealing with a debit or credit spread. This wasn’t an issue with straddles, but it should be with spreads because we’re betting on price, and obviously being in debt or having a credit is important information when betting on prices. Thus we get the next rule:
3. If you’re at a debit, your max loss is what you pay. If you’re at a credit, your max gain is what you’re paid.
This rule is very easy to remember—just think of the money leaving the account to buy the spread as permanently gone, so if you’re at a debit that’s all you can lose, and if you’re at a credit that’s all you can gain.
This brings us to rule 4, which is a mirror of rule 3:
4. The opposite of your max loss/gain is SP-SP-Paid Premium.
This sounds complicated but it’s very intuitive. For a debit spread you have paid the premium to make a bet that the stock will move past one strike price but not another, so you subtract the two strike prices and then the premium.
Take, for instance, being long 1 ABC September 30 call at 3 and short 1 ABC September 35 call at 1. I’m long ABC at 30 and short it at 35, so obviously I’m betting on a spread (hence the name) of 5. I’m paying $2 for this (buying $3 and selling $1), so that $2 is lost forever, hence 5-2 = $3 is my maximum gain.
This rule will get us the max loss and max gain for all price spreads. Which brings us to the hardest part of spreads—breakevens.
This is tough but not unbearably so. We just need to remember that debit/credit doesn’t matter for breakevens—whether there are calls or puts does. If there are calls, breakeven is lower SP + net premium and if puts it is the higher SP – net premium. For this rule we need to forget about debit/credit spreads.
Taking our prior example, we see that the lower SP is 30, add the $2 paid, we get $32 as our breakeven. Thus the rule is:
5. For spread breakevens, debit/credit doesn’t matter, calls or puts do. If calls, add net premium to the lower SP, if puts, subtract the net premium to the higher strike price.
This makes intuitive sense when you remember that calls are offers to buy, and when buying premiums are a cost that need to be added to our overall bet to determine where we’re breaking even. Similarly, puts are offers to sell, so we subtract the premium because it’s a cost that the person on the other side of the contract needs to determine when they’re breaking even.
Put together, our five rules for spreads would be:
1. Spreads are long/short a combination of two calls or two puts.
2. Spreads are horizontal (time changes), vertical (price changes), or diagonal (price/time changes)
3. If you’re at a debit, your max loss is what you pay. If you’re at a credit, your max gain is what you’re paid.
4. The opposite of your max loss/gain is SP-SP-Paid Premium.
5. For spread breakevens, debit/credit doesn’t matter, calls or puts do. If calls, add net premium to the lower SP, if puts, subtract the net premium to the higher strike price.
The typical chart used to express this information is:
| Spread Type | Position | Max Loss | Max Gain | Breakeven |
| Debit Call Spread | Long Call at Lower Strike Short Call at Higher Strike | Net Premium Paid | Strike Difference – Net Premium Paid | Lower Strike + net premium |
| Credit Call Spread | Short Call at Lower Strike Long Call at Higher Strike | Strike Difference – Net Premium Received | Net Premium Received | Lower Strike + net premium |
| Debit Put Spread | Short Put at Higher Strike Long Put at Lower Strike | Net Premium Paid | Strike Difference – Net Premium Paid | Higher Strike – net premium |
| Credit Put Spread | Long Put at Higher Strike Short Put at Lower Strike | Strike Difference – Net Premium Received | Net Premium Received | Higher Strike – net premium |
There is something of a symmetric elegance to this chart, especially when you recognize that it contains multiple dimensional symmetries in it. However, to remember the basics of options it just isn’t enough—memorizing this chart will not lead to understanding the ideas behind it! However, learning the rules of spreads and how they apply could make the Series 7 options questions a lot easier.