Option Spreads

A naked long call is a bet with an appealing shape — capped loss, unlimited gain — but it's an expensive bet, and every day that passes without the stock moving bleeds premium away through theta decay. A desk (or a retail trader) who is only moderately bullish, not wildly so, rarely just buys a call outright. Instead they build a spread: buy one option and sell another on the same underlying to partly pay for it, trading away some of the unlimited upside for a much cheaper, much more precisely-shaped bet. This is the first rung on the ladder from "single option" to "combination" — the building block behind almost every structured position a trading desk puts on. We already know American options can be exercised early; spreads built from listed American-style equity options inherit that feature too, though for a European-style spread held to expiry the payoff diagrams below are exactly what you'll realize.

Bull spreads: a capped bet that the stock rises

A bull call spread buys a call at a lower strike K_1 and sells a call at a higher strike K_2 > K_1, same expiry. Selling the higher-strike call brings in premium that offsets the cost of the one you bought — at the price of giving up any payoff above K_2. The payoff at expiry is

\text{payoff} = \max(S_T - K_1,\ 0) - \max(S_T - K_2,\ 0),

which is 0 below K_1, climbs linearly between the strikes, and flattens out at K_2 - K_1 above K_2. The same shape can be built entirely from puts instead (buy the K_1 put, sell the K_2 put) — the two constructions have different upfront cash flows but an identical payoff at expiry, a fact put–call parity guarantees.

A stock trades at \$50. You buy the K_1 = \$45 call for \$6 and sell the K_2 = \$55 call for \$2. The net cost — the debit — is 6 - 2 = \$4 per share, \$400 per 100-share contract.

Max loss — the net debit paid, \$4, realized if S_T \le K_1 = \$45 (both calls expire worthless).
Max gain — the strike width minus the debit, (55 - 45) - 4 = \$6, realized if S_T \ge K_2 = \$55.
Breakeven — K_1 plus the debit: 45 + 4 = \$49.

Compare that to a naked \$45 call costing \$6 outright: the spread costs a third less, in exchange for capping the gain at \$6 instead of leaving it unlimited. That trade-off — cheaper and more precisely targeted, in exchange for a capped upside — is the whole point of a spread.

Bear spreads: the mirror image

A bear spread is built the same way but profits when the stock falls. A bear put spread buys the higher-strike put K_2 and sells the lower-strike put K_1 < K_2 — paying a net debit for a payoff that is largest when the stock drops below K_1 and zero above K_2. (A bear call spread does the same job with calls: sell the lower-strike call, buy the higher-strike one, collecting a net credit up front instead of paying a debit — the two share the identical payoff shape, just financed in opposite directions.) In every bull or bear spread, the trader is long the option closer to the money and short the one further away, so the position always costs less than the option bought outright would.

Butterfly spreads: betting on calm

A butterfly spread combines three strikes, K_1 < K_2 < K_3, evenly spaced, all calls (or all puts), same expiry: buy one K_1 call, sell two K_2 calls, buy one K_3 call. Unlike a bull or bear spread, a butterfly isn't a directional bet at all — it pays off most if the stock finishes right at the middle strike K_2, and loses (a small, capped amount) if the stock strays far in either direction. It is, in effect, a bet that the stock stays range-bound, built entirely out of directional building blocks: a long K_1–K_2 bull spread stitched to a short K_2–K_3 bull spread.

Bull call spread (buy K_1 call, sell K_2 call, K_1 < K_2): payoff rises linearly from 0 to K_2 - K_1 as S_T crosses the strikes.
Bear put spread (buy K_2 put, sell K_1 put): the mirror image, largest when S_T is low.
Butterfly (buy K_1, sell 2× K_2, buy K_3, evenly spaced calls): a tent peaking at K_2 - K_1 when S_T = K_2, falling to (near) zero outside [K_1, K_3].

It sounds like an odd thing to trade on, but "the stock will probably stay close to where it is" is a perfectly ordinary view — think of a mature, low-volatility blue chip in a quiet news week, or a stock pinned near a round number heading into a light data calendar. A naked option can't express that view profitably (time decay eats a long option that goes nowhere, and a naked short option has unlimited risk if you're wrong). A butterfly does exactly what a "stay near here" view calls for: small, strictly capped risk on both sides, with the biggest payoff sitting right at the price you expect. It's a favourite structure precisely because it turns "I don't think much will happen" into a defined, tradeable position.

The max loss on a bull (or bear) spread is the net premium paid — it is not the distance between the strikes. Confusing "strike width" with "money at risk" is the single most common spread-pricing mistake.
The max gain on a debit spread is capped at (strike width − net debit) — a spread never has the unlimited upside of the naked option it was built from. If you want unlimited upside, don't sell the far-strike option away.
A credit spread (net premium received up front) and a debit spread (net premium paid) can have the identical strikes and expiry and still be opposite bets — always check which leg you're long and which you're short before reading off the risk.