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Spreads can be defined as the difference between the bid and the ask price of a security or asset. It is an options position established by purchasing one option and selling another of the same class, but of a different series.
The spread for an asset is influenced by: supply or float (the total number of assets outstanding that are available to trade); demand or interest in a commodity contract; total trading activity of the commodity.
For an option, the spread would be the difference between the strike price and the market value.
There are three different types of spreads available - bull spread, bear spread and butterfly spread.
BULL SPREAD: A bull spread option strategy is used by the trader who is looking to profit from an expected rise in the price of the underlying contract. Either calls or puts can be used. The lower strike price is purchased and the higher strike price is sold.
The options have the same expiration date.
BEAR SPREAD: An option strategy that seeks maximum profit when the price of the underlying security declines.
The strategy involves simultaneous purchase and sale of options which should have the same date of expiry.
It is used by futures traders who intend to profit from the decline in commodity prices while limiting potentially damaging losses. In the agri-commodity markets, this is accomplished by selling a future contract and offsetting it by purchasing a similar contract with an extended delivery date.
BUTTERFLY SPREAD: This is a neutral option strategy combining bull and bear spreads. Butterfly spreads use four option contracts with the same expiration, but three different strike prices to create a range of prices the strategy can profit from.
The trader sells two option contracts at the middle strike price and buys one option contract at a lower strike price and one option contract at a higher strike price. Both puts and calls can be used for a butterfly spread.
These have limited risk, meaning you can only lose your initial investment. Your maximum return is when the price of the underlying asset remains around the middle strike price.
The investor buys a put with a low strike, buys a put at high strike and sells two puts at intermediate strike price.
The payoff diagram resembles the shape of a butterfly, and hence the name.
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