Spreads, as we have seen, are constructed by taking positions on the long (buying the option) side while simultaneously taking a position on the short (selling the option) side of the market. Therefore, when we combine these into a spread, the unlimited risk posed by selling an option (such as our FOTM IBM call option from previous examples), is hedged by the purchase of the OTM IBM call. Figure 1 lists the major characteristics of long options which, as you may already know, offer unlimited potential profits with limited risk measured in the form of the premium paid for the option.


Clearly, if IBM moves up to the strike of the sold option and it gets in the money, it only means that the long option in the spread will be gaining, but only profitably up to the strike of the short option (where gains are offset with losses, ultimately at 100%). And as you can see in Figure 2, selling options presents just the reverse, that is, unlimited potential losses with limited potential profit. If at expiration the short option is in the money, the long option will have offset any losses incurred on the short option.


The long call will profit up to the strike of the short option, at which point the long call gains are canceled by the short call losses.



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