What Are Vertical Spreads?

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What Are Vertical Spreads?

By: Michael Tibbits, YouCanTrade

Vertical Spreads

A vertical spread is an option trading strategy that involves buying an option and selling the same type of option in a single trade. Both options used in the vertical spread will expire on the same day but will have different strike prices.

Vertical spreads can be used to reduce risks taken on a trade when compared to trading single options at the expense of capped potential gains. Vertical Spreads, as is the case with all spreads, can be categorized into two types: Debit spreads and Credit spreads.

Debit Spreads

A debit spread is when you purchase an option with a higher chance of expiring in the money (or a higher delta value) while simultaneously selling another option that has a lower chance of expiring in the money(or lower delta value). Since options with higher deltas are typically more expensive, the combination of trading these two options will result in paying a net debit for the trade, thereby making you net long in options.

One reason to do a debit spread over a single option, such as a long call or put, might be to reduce the cost of the trade. In exchange for risking less, the debit spread will also have capped a profit potential. Spreads can be used with both call options and put options. The type of spread you use depends on your outlook for a stock or index. Two examples of debit vertical spreads are the bull call spread and the bear put spread.

The Bull Call Spread

The Bull Call Spread, also known as the “long call vertical spread” or “call debit spread,” is a bullish strategy that occurs when simultaneously buying a call option with a lower strike price (or higher delta) and selling short a call option with a higher strike price (or lower delta ) that share the same underlying asset and same expiration date. If we break down the components of the bull call spread, we find that selling the cheaper option lowers the amount required to pay for the otherwise more expensive long option position. Therefore, reducing the overall risk for the trade. However, in exchange for reducing the overall risk, the bull call spread also begins to cap the gains should the underlying stock price move above the strike price of the short call.

Bull Call Spread Example

For example, If you’re bullish on a stock that’s trading at $50, you could create a Bull Call Spread like this: Buy a December call option costing $4.50 for a strike price of $50. Then on the same stock, sell a December call option with a strike price of $55 for $1.70. Because the short call has a higher strike price and is less expensive, you pay a net debit for the trade. In this spread, the debit is $2.80. To get that $2.80, you subtract the short’s premium from the cost of the long — $4.50 minus $1.70. Now, using the multiplier of 100, you get $280. So, instead of risking $450, the most you can lose on this trade is $280.

The maximum loss occurs if the underlying stock closes at $50 or lower on the expiration date. At that price, both calls are worthless.

As previously mentioned, the Bull Call Spread is different than a regular long call because your profit potential is limited by the short call. The short prevents you from potentially realizing unlimited gains. The maximum profit occurs when the underlying stock trades at $55 or higher at expiration.

If you exercise your long call at $50, the short call obligates you to sell at $55. $55 minus $50 equals $5, with a multiplier of 100, which is $500. However, your maximum profit comes from subtracting $280 from $500. This results in $220. This is the most you can make from this trade.

To determine the breakeven point — the point where you begin to see profits — add the maximum risk to the strike price for the long call. In this example, that would be $50 plus $2.80 for a breakeven point of $52.80. Everything above that is a positive return. Because the spread is a net long position, like any other long call, its value will see accelerated time decay within 30 days of expiration.

The Bear Put Spread

The Bear Put Spread, also known as the “long put vertical spread” or “put debit spread,” is a bearish strategy that occurs when simultaneously buying a put option with a higher strike price (or higher delta) and selling short a put option with a lower strike price (or lower delta) that share the same underlying asset and same expiration date.

Bear Put Spread Example

Using the same stock in the previous example, if instead of a bullish outlook, let’s say you’re bearish on a stock that’s trading at $50, you could create a bear put spread like this: Buy a December put costing $3.30 for a strike price of $50, then sell a December put with a strike price of $45 for $1.40. Because the short put has a lower strike price and is less expensive, just like with the Bull Call Spread, you pay a net debit for the trade. In this spread, the debit is $1.90. To get that $1.90, you subtract the short’s premium from the cost of the long — $3.30 minus $1.40. Now, use the multiplier of 100 to get $190. Instead of $330, the maximum risk on this trade is $190. This occurs if the underlying stock closes at $50 or higher on the expiration date. At that price, both puts are worthless.

Just like with the Bull Call Spread, the short side of the Bear Put Spread prevents you from realizing unlimited gains from the long put. If you exercise your long put at $50, the short put obligates you to buy at $45, and this would again result in $500. However, your maximum profit comes from subtracting $190 from $500. This results in $310. This is the most you can make from this trade.

To determine the breakeven point, subtract the maximum risk — $1.90 — from the strike price for the long put — $50. That gives a breakeven point of $48.10. Everything below that is a positive return, and maximum return occurs below $45.

Credit Spreads

A credit spread is simply the opposite of a debit spread. Credit spreads are built by short selling the option with a higher chance of expiring in the money (or a higher delta value) while simultaneously buying another option that has a lower chance of expiring in the money (or lower delta value). Since options with higher deltas are typically more expensive, the combination of these two transactions will result in receiving a net credit for the trade, thereby making you a net short in options.

One reason to do a credit spread, rather than selling a naked call or put, might be to try and collect income in the form of option premium while establishing predefined risks. Should an assignment take place, the long option of the credit spread serves as a cap to limit losses in case the underlying asset blows past the short option’s strike price.

Usually, the goal for trading a credit spread is to take advantage of time decay in the options in hopes there is little movement in the underlying asset so that both options expire worthless. If both options expire worthless, then 100% of the credit collected from trading the credit spread is kept. However, traders can also choose close out of the credit spread after time has eroded most of the value making them cheaper to buy to cover. Two examples of credit vertical spreads are the bear call spread and the bull put spread.

The Bear Call Spread

The Bear Call Spread, also known as the “short call vertical spread” or “call credit spread,” is a bearish strategy that occurs when simultaneously short selling a call option with a lower strike price (or higher delta) and buying a call option with a higher strike price (or lower delta ) that share the same underlying asset and same expiration date. Selling the lower strike call will generate more than enough credit to purchase the cheaper long option position, which leaves a net credit in the account. This net credit is the maximum profit.

Bear Call Spread Example

For example, If you’re bearish on a stock that’s trading at $50, you could create a Bear Call Spread like this: Sell a December call option costing $3.50 for a strike price of $55. Then on the same stock, buy a December call option with a strike price of $60 for $1.00. Because the short call has a lower strike price and is more expensive, you receive a net credit of $2.50 for the trade. To get that $2.50, you subtract the long premium from the credit received from the short — $3.50 minus $1.00. Now, using the multiplier of 100, you get $250, which is the most you can make on this trade.

The maximum loss occurs if the underlying stock at $60 or higher on the expiration date. At that price, both calls would expire in the money and you would have to exercise the 60 strike call to cover the 55 strike call assignment. After exercising the 60 call to close out of the assigned stock position, you would be down $500 because $55 – $60 – is equal to -$5. Factoring in the multiplier of 100, that would be -$500. However, since you collected a credit of +$250 for the bear call spread, the overall loss would be -$250.

The long option in the Bear Call Spread plays an important role in capping off the losses should the underlying asset move indefinitely higher than the 60 strike call.

The breakeven for this trade is calculated by adding the the lower strike to the net credit received. In this case, it would be $55+$2.50, which is equal to $57.50. If the underlying stock closes below this number on expiration day, the bear call spread will incur losses.

The Bull Put Spread

The Bull Put Spread, also known as the “short put vertical spread” or “put credit spread,” occurs when simultaneously selling a put option with a higher strike price (or higher delta) and buying a put option with a lower strike price (or lower delta) that share the same underlying asset and same expiration date.

Bull Put Spread Example

So let’s say you’re bullish on a stock that’s trading at $55, you could create a Bull Put Spread like this: Sell a December put costing $3.50 for a strike price of $50, then buy a December put with a strike price of $45 for $1.50. Because the short put has a higher strike price and is less expensive, you receive a net credit for the trade. In this spread, the credit is $2.00. To get that $2.00, you subtract the cost of the long premium from the credit received from selling the short— $3.50 credit minus $1.50. Now, use the multiplier of 100 to get $200. This is the most you can make on this trade.

The maximum loss occurs if the underlying stock moves to 45 or lower on the expiration date. At that price, both put would expire in the money and you would have to exercise the 45 strike put to cover the 50 strike put assignment. After exercising the 45 put to close out of the assigned stock position, you would be down $500 because $45 – $50 – is equal to -$5. Factoring in the multiplier of 100, that would be -$500. However, since you collected a credit of +$200 for the bull put spread, the overall loss would be -$300.

The long option in the bull put spread plays an important role in capping off the losses should the underlying asset fall to zero.

The breakeven for this trade is calculated by subtracting the net credit received from the higher strike. In this case, it would be $50-$2.50, which is equal to $47.50. If the underlying stock closes below this number on expiration day, the bull put spread will incur losses.

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2021-09-07T14:19:27-04:00
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