Perhaps you're an experienced options trader and know what these terms mean. Perhaps you're a newbie to options trading. Although you've heard of the terms, you can't quite keep it straight which one sells what option or buys what option. Either way, perhaps it's helpful to look at a visual that shows the derivation of the terms. They're derived from a common layout of the option chain.
Graph Showing a Vertical, Horizontal and Diagonal Option Spread, Graph by OptionNETExporer:
Fixing this typical layout for an option chain in your mind helps you remember which option spread is which. Please do not, however, fix my inept drawing skills in your mind.
An option spread involves buying options and selling options. The options bought and sold are separated by a spread of points or time or both. Spreads can return a credit or premium to the options trader or can require a debit to enter. They can be helped or hurt by the movement of the underlying, the passage of time or changes in implied volatility, depending on how they're constructed. In terms of the Greeks of option trading, that means that they can be positive or negative delta, theta or vega.
Let's take the case of a vertical spread, shown above by put vertical in the vertically aligned outlined box: -1 DEC 14 1170 P/+1 DEC 14 1160 P. The derivation of the name "vertical spread" is now easy to determine. The two strikes are aligned vertically on the typical layout for an option chain. Both are in the same expiration cycle. This spread is a 10-point spread in prices. This type of spread is also often called a credit spread because it returns a credit to the options trader. However, it also requires maintenance or margin. Unless otherwise noted, all graphs are by OptionNetExplorer or ONE.
Vertical Spread Example:
Because the more valuable 1170 put was sold and the less valuable 1160 was bought as a hedge, this vertical was initiated with a premium or credit coming back to the trader. That credit after two-way commissions was $345.00. However, as is visible by eyeballing the chart, a higher risk is incurred. The trader with this vertical incurs a max margin of $655.00. Although this is called the "max margin," be aware that holding such a spread into expiration can incur extra costs if the underlying is a stock that can be assigned or called and one or more of the options is in the money. An exception can also occur if the underlying is a dividend-paying security and goes ex-dividend close to expiration, and one of the options is in the money. These caveats to the "max margin" guidelines are specialized cases that seldom occur. However, they will apply to all the spreads, so I won't repeat it each time.
ONE also calculates the exact margin on a part of its analyze page that I haven't shown. That risk can also be calculated by the trader, using following formula: [(Spread in price x 100 multiplier x number of contracts) - premium received + commissions]. This trade benefits from a rise in the RUT's price (positive-delta trade). Whether or not it benefits from the passage of time depends on where price is on the chart. If the RUT's price is above the expiration breakeven, theta is positive and the profit is improved as time passes and the "today" line rises to meet the expiration graph. If the RUT's price is below the expiration breakeven, theta is negative and the loss grows bigger as time passes and the "today" line sinks to meet the expiration graph. The effect of a rise or fall of implied volatilities also depends on where the RUT's price is in relationship with the expiration breakeven. If the RUT's price is above the expiration breakeven, vega is negative and gains are tempered if implied volatilities rise. If the RUT's price is below the expiration breakeven, vega is positive, and losses are tempered if implied volatilities rise.
Vertical spreads can be constructed so that the higher-cost option is bought and the lower one sold, and these incur a debit. That debit, plus the commission cost and possible slippage, are the maximum cost or risk in the trade, as long as they're closed out before expiration.
Let's move on to a different type of spread. The first graph also displayed an aptly named horizontal spread. The graph below is the expiration graph for that spread.
Horizontal Spread -1 19 DEC 14 1180 Call/+1 31 DEC 1180 Call:
These spreads are also called "time spreads" or "calendar spreads," and their expiration graph looks much different than a vertical spread's graph. There is no spread in the strike prices since both the sold and the bought option are 1180 calls, but there is a spread in time. The sold option is a 19 DEC call, and the bought one is a 31 DEC call, so they're spread out in time. Note that I would ordinarily have gone out to the monthly January expiration cycle to buy the hedging long, but I inadvertently marked the first chart without noticing that I had included the 31 DEC cycle instead. There's no rule that it couldn't be used, but I would want to check volume and such other considerations before using a non-standard monthly option to construct a calendar spread. Many people prefer to have at least a month's spread between the sold and bought option.
This calendar looks a bit like a butterfly except that the wings curve away toward the maximum loss. Whenever you see curving lines like that on the expiration graph, you can intuit immediately that options in different expiration cycles are included the makeup of that option trade.
This is a debit position. The cost of initiating the trade, including two-ways commissions is $440.00. That's also the maximum loss in most cases.
This horizontal spread, this calendar, is a positive-vega and theta position, meaning that it benefits from a rise in implied volatilities and the passage of time. That's because the bought option's expiration is further out in time. That option has more "time" premium or extrinsic value to be plumped up when implied volatilities rise. Rising implied volatilities mean that the long, further-out-in-time option rises in value faster than the nearer-term option with extrinsic value.
Theoretically. This is not a how-to for trading calendars but rather a brief introduction and graphic illustration of how these various trades get their names. You won't be getting an in-depth explanation of trading these calendars from me because I don't fare well with them, although others do. The problem with that theory about rising implied volatilities helping them depends on why implied volatilities are rising. If, for example, traders expect a big market-moving event before the 19 DEC expiration but think that the movement will be brief and all will return to the norm before the 31 DEC expiration, the sold option may increase in value a bigger percentage than the long option because the sold option's implied volatilities may go up but the long options may stay stable. That hurts your profit and loss line.
The calendar's biggest foe, however, is what is known as a "vol crush," a crushing drop in implied volatilities, often also accompanied by a unrelenting climb in the underlying's prices. Under those conditions, that "today" line sinks ever lower. That means that any potential adjustments made because prices are rising rapidly toward the expiration breakeven will be locking in some significant losses. I personally haven't found a good way to overcome that effect. Like butterflies, calendars offer plenty of profit potential and can be adjusted, but they're just not my personal favorite.
Diagonal spreads have elements of both the vertical and horizontal spreads: they're spread across both time and strikes.
-1 19 DEC 1200 Call/+1 31 DEC 1220 Call:
This diagonal shows the expected curving lines on the expiration graph since the bought and sold options are in different expiration cycles. Diagonals are flexible trades and can be constructed to meet the trader's expectations for what will happen with both price and implied volatilities. This flexibility results from the ability to move the long further out in time or spread it further out in price, or both.
As shown, this trade returned a credit or premium when initiated, but that credit or premium is smaller than it would most like be if the trade were a vertical. The long option has more time or extrinsic value, so it's more costly by far than a 1220 option in the 19 DEC expiration cycle. It cuts into the premium gained by selling the 19 DEC 1200 call.
Diagonals are flexible structure, depending on the premium desired and the margin that's comfortable for the trader. Call diagonals and put diagonals can work together to form a double-diagonal structure.
One Example of a Double Diagonal:
This structure looks a little like the iron condor, but the curving lines in the expiration graph betray it as different, including options in different expiration cycles. There's another big difference: as this particular DD is constructed, this is a positive-vega trade, theoretically benefiting from a rise in implied volatilities rather than being hurt by them. Like the calendar, however, this trade can be subject to a vol crush. When I traded it, it always seemed more able to tolerate such occurrences than the calendar. For a while, I thought this was going to be my go-to trade. Like the butterfly, it seemed possible to adjust this trade and still have enough profit potential to keep the trade viable. I liked it.
Initiating this trade returns a credit to the trader, like the iron condor, and it requires a margin. And it's that margin that has caused the most problems for traders in recent years. FINRA's heightened imposition of its definitions for traditional option structures meant that most or maybe all brokerages suddenly began margining this trade on both sides, double-margining it, as some traders considered the practice. Many traders abandoned them as their preferred trade. I was one of those. Since I am satisfied with the butterfly I now trade as my preferred trade, I haven't gone back.
However, this wasn't meant to be a treatise recommending any particular trade. Rather, it was an effort to provide a visual way to remember the various names of the spreads and understand how those names were derived. If you're interested in any of these trades, please investigate pros and cons. Try some simulated trades, at least, and do consult the margin desk at your brokerage for information about how margin will be handled. Always begin small with live trades and attempt live trades only after you have decided on adjustment practices that fit your style of trading.