Analysis of Spread Strategies in Derivative Market

This article provides an analysis of spread strategies in the derivative market. It explains the concepts of vertical, horizontal, and diagonal spreads, and discusses their risks and benefits. The article also emphasizes the importance of understanding the underlying asset and the option market before implementing spread strategies.

Running head: ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
Analysis of Spread Strategies in Derivative Market
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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
1. Introduction:
Spread strategies are the basic theme for trading in option market. In option-spread
strategy, one can enter into two or more contracts of buying and selling the option contract to
mitigate the risk involved in option market. Spread strategy generally provides certainty of
risk associated in option contracts with estimated range of loss or profit to be achieved. The
main motive behind spread strategy to hedge against loss from unpredictable fluctuation in
the price of the underlying assets. A speculator will always try to earn profit from the
difference between price movements of two option contracts of same underlying asset. In
option-spread strategies, directional trade strategy is followed to achieve statistically higher
return for same risk level.1
There are two types of spread strategy:
1. Vertical spread strategy.
2. Horizontal spread strategy.
However, there is one more strategy, which is the combination of Vertical spread
strategy, and Horizontal spread strategy i.e. Diagonal spread strategy. Whatever strategy an
investor is adopting, should be adopted by the deep study of the Gamma, Vega and Theta of
the underlying asset to understand the inherent risk and to determine the intrinsic value of the
underlying stock2.
2. Horizontal Spread strategy:
1 Hull, John. Options, futures and other derivatives/John C. Hull. Upper Saddle River, NJ: Prentice Hall,, 2009.
2 Chance, Don M., and Roberts Brooks. Introduction to derivatives and risk management. Cengage Learning,
2013.

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
In a Horizontal spread strategy, the investor used to buy and sell options at the same
strike price with different expiration dates. The main motive behind this strategy is to protect
from unwanted volatility in the price of the underlying asset. This strategy can be applied in
both call and put option depending upon the price volatility belief of the person. This strategy
enjoys time decay benefit of option contract where investor has belief that volatility of the
price of the underlying asset will be affected by the theory of time value of money. The return
in the horizontal spread mostly depends upon the time decay and volatility level of the stock.
The volatility of the stock means statistics of the changes in the price of the underlying asset
in a time horizon. This strategy generally result in limited loss or profit due to selling and
buying option at different exercise prices at different point of time by securing the gap
between both exercise prices as insurance against the loss. The whole strategy can be
explained through the example given below.
Suppose, in the month of June, an investor has purchased call option with a strike
price of $ 250 with expiration date of August end by paying premium of $ 40 and sold call
option ending in the October with premium inflow of $20 at exercise price of $ 280. So, the
investor has limited loss of $ 20 whether the price has gone above $280 or remained below
$250. Let’s explain it through different prices on the exercise date.3
Particulars Price at the expiration date
Strategies 250 $ 280 $ 300 $ 320 $ 340 $ 360
c+ at E= $250 $ - $ 30 $ 50 $ 70 $ 90 $ 110
C- at E= $280 $ - $ - $ (20) $ (40) $ (60) $ (80)
$ - $ 30 $ 30 $ 30 $ 30 $ 30
Less: Net premium outflow. 20 $ 20 $ 20 $ 20 $ 20 $ 20
Profit $ (20) $ 10 $ 10 $ 10 $ 10 $ 10
3 McKeon, Ryan. "Option spread trades: Returns on directional and volatility trades." Journal of Asset
Management 17.6 (2016): 422-433.

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
From above example, it can be seen that the investor has secured himself from risk of
unlimited loss.
2. Vertical spread strategy:
A vertical spread strategy means buying and selling option at different strikes price at
same expiry period. A vertical spread has two legs, one leg for buying the option and another
for selling or writing the option. This can result into debit or credit position to the interested
person. Debit position means that the investor has paid more premium while buying option
as compared to the writing an option whereas in a credit position has gained more premium in
writing as compared to the buying the option. The main magic of the vertical spread strategy
is of predetermined risk of loss that is known to the investor. If an investor deals in an option
market without any spread strategy then the chance of risk of loss is 100%. In many stocks,
there are more option volatility and margin requirements are the reason for acting as a
restriction for freely trade in option market whereas in a vertical spread strategy, due to two
legs of option trade in it, investors are not exposed to such restrictions of margin
requirements. To create a better vertical spread strategy, one should understand the
relationship between the stock price and the strike price. When the strike price and stock
price are closer to each other. In such case, the Gamma, Theta and Vega will always be
higher for that strike price and will affect the investment decision of investor. The gamma can
be positive or negative depending upon the movement in stock price in relation to the strike
price. If the stock price moves to the closer of strike price, the resulting gamma will be higher
and will be lower if the stock price is far away from the strike price. Volatility in the price of
the stock plays key role in determining the status of the option whether it is “In the money” or
“Out of the money”. If there is increase in volatility the ITM status of vertical spread strategy
will decrease and OTM status will increase. Intrinsic value concept is useful in determining
inherent return potential of the stock. It determines whether a stock is overvalued or

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
undervalued depending upon which, investors perspective regarding option buying and
selling is affected.4
There are four types of vertical spread strategy;
 A bull call spread: buying a call and selling a call at a higher exercise price with
same expiration period. It will always have a positive beta and will be equal to the
bull put vertical spread strategy.
 A bull put spread: buying a put option and selling a put option at a lower exercise
price. It will always have positive beta. The sum total of beta of bull call spread and
bull put spread will be always equal to 1 because the sum of absolute values with
same variables will be equal to 1.
 A bearish call spread selling a call option and simultaneously buying a call option at
higher exercise price. It will always have a negative beta.
 A bearish put spread: buying a put option and selling another put option at a lower
strike price.5
The whole outcomes and the process will be explained from the table given below:
4 Tosi, Adriano, and Alexandre Ziegler. "The Timing of Option Returns." (2017).
5 Bartram, Söhnke M. "Corporate hedging and speculation with derivatives." Journal of Corporate
Finance (2017).

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
3. Diagonal spread strategy:
It is the combination of vertical and horizontal spread strategy where investor buy and
sell same option either call or put with different exercise prices at different expiry periods.
This strategy has both time and price component i.e. buying an option from a long term
perspective and selling an option from a short term perspective. Diagonal spread strategy is
mainly of two types, one is “In the money diagonal spread strategy” and another is “Out of
the money diagonal spread strategy”. 6
 In the money, Diagonal spread Strategy: In this investor generally chooses to hold
long position to enjoy the benefit of undervaluation of the underlying asset. The
investor has reasonable ground to believe that the price of the underlying asset will go
up in near future.
 Out of the money, Diagonal spread strategy: Investor has a feeling of short
position because it will result in short vertical spread when complete. In this, the
expected intrinsic value achievable at the end of contract is more than what actually
being provided by the contract. So, investors in this strategy, always prefers to go
short position and hold that position till expiry of the contract.7
6 Banerjee, Snehal, and Jeremy J. Graveline. "Trading in derivatives when the underlying is scarce." Journal of
Financial Economics 111.3 (2014): 589-608.

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
It behaves like a covered call writing with minimum cost of equity. In this maximum loss
potential to the investor is equal to the Net premium paid and maximum gain is equal to the
width of the spread. Hence, the investor has certain risk of loss, which is insured by the
spread strategy from uneven fluctuations in the price. The creation of diagonal spread
strategy is very important. Without proper planning of diagonal strategy, one could lose
money if the trader moves in fast forward direction. Setup under diagonal strategy involves
following steps listed below:
 Executing equal number of options.
 Options for same class of underlying asset.
 Options with different strike prices and expiration dates.
A diagonal call spread will somehow look like this:
Profit Max profit at short strike.
A B Break even
Loss Max loss = Unlimited
7 Clewlow, Les, and Stewart Hodges. "Optimal delta-hedging under transactions costs." Journal of Economic
Dynamics and Control 21.8-9 (1997): 1353-1376.

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
4. Conclusion:
From the above discussion, it can be concluded that the spread strategy is mostly used
to mitigate the risk associated in option market but it requires significant knowledge and
experience of the option market and the nature of the underlying stock.
One should always be aware of the margin requirement and commission that are
associated with the option contracts because it will cost to the investors. A complex spread
strategy will always have more burden of commission charges and brokerage fees. Thus
before getting involve in a spread strategy, due consideration will be provided to the margin
requirements and other cost incidental to the option contracts.
5. References:
1. Avellaneda, Marco, Arnon Levy∗, and Antonio Parás. "Pricing and hedging derivative securities in
markets with uncertain volatilities." Applied Mathematical Finance 2.2 (1995): 73-88.
2. Banerjee, Snehal, and Jeremy J. Graveline. "Trading in derivatives when the underlying is
scarce." Journal of Financial Economics 111.3 (2014): 589-608.
3. Bartram, Söhnke M. "Corporate hedging and speculation with derivatives." Journal of Corporate
Finance (2017).
4. Battiston, Stefano, et al. "Complex derivatives." Nature Physics 9.3 (2013): 123.
5. Bodie, Z., A. Kane, and A. J. Marcus. "Investments Seventh Edition International." (2008).
6. Chance, Don M., and Roberts Brooks. Introduction to derivatives and risk management. Cengage
Learning, 2015.

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ANALYSIS OF SPREAD STRATEGIES IN DERIVATIVE MARKET
7. Clewlow, Les, and Stewart Hodges. "Optimal delta-hedging under transactions costs." Journal of
Economic Dynamics and Control 21.8-9 (1997): 1353-1376.
8. Hull, John. Options, futures and other derivatives/John C. Hull. Upper Saddle River, NJ: Prentice
Hall,, 2009.
9. Lee, Cheng-Few, et al. "Portfolio Analysis and Option Strategies." Essentials of Excel, Excel VBA, SAS
and Minitab for Statistical and Financial Analyses. Springer, Cham, 2016. 919-946.
10. McKeon, Ryan. "Option spread trades: Returns on directional and volatility trades." Journal of Asset
Management 17.6 (2016): 422-433.
11. Tosi, Adriano, and Alexandre Ziegler. "The Timing of Option Returns." (2017).
12. Windcliff, H., Peter A. Forsyth, and Kenneth R. Vetzal. "Pricing methods and hedging strategies for
volatility derivatives." Journal of Banking & Finance 30.2 (2006): 409-431.