Chapter 04 · Combining option positions
Spreads and a defined loss
A spread buys one option and sells another on the same underlying and expiry, at different strikes, in the same quantity. Done and kept that way, the most you can lose is known at the start. This chapter builds one call spread in rupees and then lists the ways the definition gets broken.
A call spread, built slowly
The underlying is ₹1,000. You buy a call at a strike of ₹1,000 for ₹30 and sell a call at a strike of ₹1,060 for ₹12, same expiry, same lot of 100. Net premium paid: ₹18 a share, or ₹1,800 for the lot. You need the underlying to finish high enough to earn that ₹18 back. You will never earn more than the width of the strikes, minus what you paid.
| Underlying at expiry | 1000-strike call | 1060-strike short call | Net versus the ₹18 paid |
|---|---|---|---|
| ₹980 | Expires worthless | Expires worthless | Loss of ₹18. This is the most you lose at expiry. |
| ₹1,018 | Worth ₹18 | Worthless | About flat, before charges. |
| ₹1,040 | Worth ₹40 | Worthless | Gain of ₹22. |
| ₹1,100 | Worth ₹100 | Worth ₹40 against you | Gain of ₹100 − ₹40 − ₹18 = ₹42. The width was ₹60. You paid ₹18. The most you keep at expiry is ₹42. |
The shape is the lesson. Below the lower strike you lose the net premium and nothing more, at expiry, if both legs are still on. Between the strikes you gain as the underlying rises. Above the higher strike the short call gives the extra gain back, one rupee for each rupee the long call makes. The position has a floor and a ceiling. You bought the floor and the ceiling together when you refused to pay ₹30 for the naked call and paid ₹18 for a capped one.
Why someone would refuse the uncapped call
Paying ₹30 for the ₹1,000 call makes sense if you think a move far beyond ₹1,060 is plausible enough to pay for. Paying ₹18 for the spread makes sense if you think the likely happy outcome is a moderate rise and you do not want to fund the lottery ticket above ₹1,060. Neither is braver. They are different beliefs about how far the move goes. Write the belief down. If you actually think ₹1,200 is the interesting outcome, the spread is the wrong thrift.
How a defined loss becomes undefined
- You close the long ₹1,000 call because it is profitable, and you leave the short ₹1,060 call open. You are now naked short a call. The ceiling is gone and so is the floor.
- The quantities differ. Long two lots and short one is not this spread. It is this spread plus an extra long call, and the loss on a sharp fall is the extra premium.
- The expiries differ. A long near-month call and a short far-month call is a calendar, with a different risk, including a risk after the near month dies.
- You ‘leg in’, sending one order now and the other if the price improves. For the minutes or days in between, you hold the naked leg. The defined loss begins only when both exist.
Before expiry the ₹1,800 is not a sealed box
The table is an expiry table. A week after you enter, the underlying can be unchanged and the spread can still be worth less, because time has passed and the market’s price of movement may have fallen. It can also be worth more. Mark-to-market will show a loss inside the ₹1,800 even though the expiry loss cannot exceed that net premium if the position is held intact. People abandon spreads in that intermediate loss and then re-enter worse. Decide at the start whether you are holding to expiry or closing at a written level. Do not invent the rule on a red afternoon.
What to remember
- A vertical spread’s expiry loss is capped at the net premium if you paid, or at the strike width minus the net credit if you were paid.
- The expiry gain is capped at the strike width minus the net premium you paid.
- The cap and the floor exist only while both legs are on in equal quantity.
- Closing the long leg and keeping the short leg removes the definition.
- Expiry diagrams do not describe the mark next week. Write the exit rule before you need it.