What Are Alternative Spreads in Options Trading?

Options trading involves contracts that grant the buyer the right, but not the obligation, to buy or sell an underlying asset at a predetermined price by a specific date. Traders often combine multiple options contracts into strategies known as options spreads to manage risk and achieve various market exposures. While some spreads are straightforward, others incorporate more complex structural elements. These nuanced arrangements, deviating from simpler forms, are called “alternative spreads,” introducing variations in key parameters.

Defining Alternative Spreads

Alternative spreads diverge from straightforward “vanilla” options strategies, such as vertical spreads, which use two options contracts with the same expiration date and underlying asset, differing only in strike prices. The “alternative” designation highlights non-standard relationships where one or more fundamental parameters are varied.

This can manifest as options with differing expiration dates, often termed horizontal or time spreads, introducing a temporal dimension. Structural variations may also involve combining options with distinct strike prices and different expiration dates, resulting in a diagonal arrangement. Another departure includes non-linear combinations, where an unequal number of options contracts are employed, altering proportional exposure. These structural differences enable a wider array of market exposures, influencing how the spread reacts to changes in market variables like time decay, volatility, and price movement.

Illustrative Alternative Spread Structures

Calendar Spread

One common alternative spread is the Calendar Spread, also known as a Horizontal Spread or Time Spread. This structure involves simultaneously buying and selling options of the same type (calls or puts) with identical strike prices but different expiration dates. Typically, a near-term option is sold and a longer-term option is purchased. Both options are based on the same underlying asset.

Diagonal Spread

The Diagonal Spread integrates elements from both vertical and horizontal spreads. It is formed by simultaneously holding long and short positions in two options of the same type on the same underlying asset. These options possess both different strike prices and different expiration dates. For example, one might buy a longer-dated option at a lower strike price and sell a shorter-dated option at a higher strike price. The term “diagonal” represents how these options appear on an options chain, cutting across both strike prices and expiration dates.

Ratio Spread

The Ratio Spread employs an unequal number of options contracts, making it a distinct alternative structure. Unlike standard spreads with equal bought and sold contracts, a ratio spread involves a disproportionate quantity in each leg, such as buying one and selling two or more. These spreads typically consist of options of the same type (calls or puts) and often have the same expiration date, though they can incorporate different strike prices. This deliberate imbalance creates unique sensitivities to price movements.

Key Structural Attributes

Time Decay (Theta)

The distinct structural designs of alternative spreads influence their behavioral characteristics, differentiating them from simpler strategies. For spreads with different expiration dates, like calendar and diagonal spreads, a primary attribute is their unique sensitivity to time decay, known as theta. Options with closer expiration dates decay faster than those with longer maturities. This differential decay means the position’s overall value is affected by time in a nuanced way, as the short-dated option rapidly loses extrinsic value while the long-dated option decays more slowly.

Ratio Spread Sensitivity

For ratio spreads, the unequal number of options contracts fundamentally alters exposure to price movements non-linearly. While standard spreads aim for balanced directional exposure, the imbalance in a ratio spread means the position’s delta (sensitivity to underlying price changes) can shift significantly. This results in asymmetric risk and reward profiles due to the disproportionate number of long and short contracts. The differing quantities mean the spread’s overall sensitivity becomes more pronounced as the underlying price reaches certain levels.