Mastering Vertical Option Spreads

‘A complex strategy that caps my potential profits? No thanks.’ 

But wait, hear us out. 

Vertical Option Spreads have this strange reputation of being a lot more complicated than they really are. Because of this, new traders make the mistake of dismissing spreads without taking into account their proper purpose – to minimise risk. 

By predefining risk and reward, vertical option spreads can be used to profit from market price increases, decreases and sideways movement. They form the building blocks of more advanced option spread strategies like the Iron Condor, Butterfly, and Back Ratio, to name a few. But before we touch on those advanced strategies, we’ll help you master the basics of vertical options spread. 

What are Vertical Option Spreads?

Vertical option spreads involve the simultaneous buying and selling of two options (call or put) of the same stock, with the same expiration date, just at different strike prices. 

As spreads involve both the buying and selling (or writing) of an option, the theory goes that the proceeds from the sale should offset the purchase of the option. This lowers the cost of the trade overall, while also mitigating the risk involved. Although, the trade-off for minimizing risk is the capping of potential gain. Because of this cap on potential profit, vertical spreads are not an appropriate strategy if the underlying stock is expected to breakout into a substantial trend. Rather, vertical spreads are best used when modest price action is expected in the underlying.

Vertical spreads can be separated into two categories: debit spreads and credit spreads. 

Vertical Debit Spreads

What is a vertical debit spread?

The setup of a vertical debit spread – Buy high premiums options while simultaneously selling low premium options. It costs money to put on this type of spread and results in a debit from the trader’s account. 

The purpose of a vertical debit spread – To reduce the premium amount payable for the position.

Examples of a vertical debit spread – Bull Call Spread & Bear Put Spread.

Vertical Credit Spreads

What are vertical credit spreads?

The setup of a vertical credit spread – Sell high premium options while buying low premium options.  The trader receives a premium for putting on this postion and results in a credit to the trader’s account. 

The purpose of a vertical credit spread – To reduce the risk involved in putting on the option positions.

Examples of a vertical credit spread – Bear Call Spread & Bull Put Spread.

Vertical Spreads vs Naked Options

What is the difference between vertical spreads vs naked options?

Option writers take on substantial risk to receive a comparatively small amount of option premium. Where traders don’t own the underlying stock, writing naked or uncovered options is one of the most dangerous strategies out there. Selling naked calls carries unlimited potential loss if a trade goes the wrong way. For naked puts, traders could be left holding a large number of unwanted stocks in a market downturn. The consequences of just one bad trade could potentially wipe out all other wins.

Vertical Spreads are much less risky than writing naked options. While they limit the upside profit potential, they predefine and mitigate risk — which is the key to successful longevity trading. 

They are also less sensitive to the Greeks. Since option spreads involve one long and one short position, they are affected less by time decay, movement in the underlying price, and changes in volatility.

There are four basic types of vertical spread strategies: Bull Call Spread, Bear Call Spread, Bull Put Spread, and Bear Put Spread. We consider each of these options trading strategies below.

Bull Call Spread 

The Bull Call Spread also known as Call Debit Spreads, involves simultaneously purchasing a call option and selling a call option of higher strike. 

Bull call spreads are also a type of Vertical Debit Spread in that it costs money to put on the trade. Since elevated volatility in stocks can also substantially increase the cost of stock options, making call options  expensive; Bull Call Spreads can be used as a strategy to reduce the overall cost of the call position.  

This strategy is best used when a trader expects a moderate upside movement rather than huge upward gains.

If the stock falls and expires below the lower strike price, the option strategy expires worthless. The trader’s losses will be limited to the net cost involved in purchasing the spread. 

If the stock price rises and expires above the higher strike price, the trader exercises their first option and purchases the shares at a lower strike, then sells the shares at the second higher strike price. The trader’s gains are the difference in strike price of the calls less the premium paid for the spread. The downside is that if the stock skyrockets upward, the trader forfeits any price moves above the strike price of the sold call option.  

If the stock price expires in between the strike prices, the gains or losses will be reduced. The breakeven point will be the higher strike price minus the net premium paid for the position.

vertical option spreads - bull call spread

Bear Call Spread

The Bear Call Spread also known as Call Credit Spreads, involves simultaneously selling a call option and purchasing a call option of higher strike.

Bear Call Spreads are a type of Vertical Credit Spreads in that the trader receives a credit for putting on the position. Selling a stock short carries unlimited risk, therefore bear call spreads can be used to reduce the net risk of the overall call option. 

This strategy is used when volatility is high and the trader expects a moderate downside or sideways movement of the stock.

If the stock declines and expires below the lower strike price, both options expire worthless and the trader gets to keep the credit they received for putting on the spread.

If the stock price rises and expires above the higher strike price, the trader exercises their second option and purchases the shares at a higher strike, then sells the shares at the first lower strike. The trader’s loss will be the net cost of the premiums of the call options. 

If the stock expires between the strike prices, the gains or losses will be reduced. The breakeven point will be the lower strike price plus the credit received. 

vertical option spreads - bear call spread

Bull Put Spread

The Bull Put Spread also known as Put Credit Spreads, involves simultaneously selling a put option and purchasing a put option of lower strike. 

Bull Put Spreads are a type of Vertical Credit Spreads in that the trader receives a credit for putting on the position.

This strategy is used when a trader expects a moderate upside or sideways movement of the stock price until expiration. 

If the stock drops and expires below the lower strike price, the short put is assigned and the long put is exercised. The trader’s maximum loss is realised. The loss will be the difference in strike price of the puts less the credit received.

If the stock price rises and expires above the higher strike price, both options expire worthless. The trader will then get to keep the credit taken for entering the position. 

If the stock price expires in between the strike prices, the gains or losses will be reduced. The breakeven point will be the short put strike minus the credit received for the position.

vertical option spreads - bull put spread

Bear Put Spread

The Bear Put Spread also known as Put Debit Spreads, involves simultaneously buying a put option and selling a put option of lower strike. 

Bear put spreads are also a type of Vertical Debit Spread in that it costs money to put on the trade. Selling the put with the lower strike price helps offset the cost of purchasing the put option with the higher strike price. 

This strategy is used when a trader expects a moderate downside movement of the stock price but not a huge downward trend.

If the stock falls and expires below the lower strike price, the long put is exercised and the short put is assigned, resulting in the stock being purchased at the lower strike and sold at the higher strike. The trader’s gains are the net cost of the premiums of the put options. The downside is that if the stock falls dramatically, the trader forfeits any price moves below the strike price of the lower put option. 

If the stock price rises and expires above the higher strike price, the option strategy expires worthless. The trader’s losses will be limited to the amount spent in purchasing the spread. 

If the stock price expires in between the strike prices, the gains or losses will be reduced. The breakeven point will be the long put strike minus the premium paid for the position.

vertical option spreads - bear put spread

Selecting Strike Price

When it comes to selecting your strike prices, the optimal strike is largely subjective and will be dependent on the strategy you are using and your outlook for the stock.

Debit Spreads

  • Buy ITM and Sell OTM –  When buying in-the-money and selling out-the-money options, there is a higher probability that the trade will be successful as the stock price doesn’t have to move for the position to be profitable at expiration. However, the tradeoff is that buying ITM options are more expensive, thereby increasing your loss potential. 
  • Buy OTM and Sell OTM – When buying out-the-money and selling out-the-money options, there is lower probability that the trade will be successful. This is because the stock will need to move in your direction, otherwise it will expire worthless. However, the trade will not be as expensive, thereby reducing your loss potential. 

Credit Spreads

  • Sell ATM and Buy OTM – When selling at-the-money and buying out-the-money options, there is a lower probability that the trade will be successful as there’s little room for the stock price to move against you. However, there is more profit potential. 
  • Sell OTM and Buy OTM – When selling out-the-money and buying further out-the-money options, there is a higher probability that the trade will be successful as there’s more room for the stock price to move against you before it can turn in-the-money. However, there is less profit potential.

When to take profits?

Remember there is a cap on the profit potential of all vertical option spreads. Due to this limited profit potential, the most appropriate and logical time to take profits is when the spread approaches its maximum profit value. 

For debit spreads, this means when the spread nears its maximum value. For credit spreads, this means when the spread’s price gets close to $0.  This is because there is less profit to make and much more to lose if stock price shifts dramatically.

One thing that also must be considered before putting on a spread, is the risk of early assignment. Remember stock options can be exercised on any business day up until expiration. If early assignment does occur, in most cases the logical thing to do will be to close the position by exercising the long call. However, additional fees may be applicable and assignment could also trigger a margin call if there is insufficient equity in your account to support the stock position. 

Regardless of whether the market moves upwards, downwards or sideways, there is a vertical option spreads strategy available to help you take advantage of modest price movements in a risk defined manner.  Markets do not always move in sharp upwards or downwards trends. Learning how to utilize vertical spreads to benefit from modest price fluctuations will make you a more well-rounded trader. As always, don’t be afraid to test, observe, and learn new strategies.

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