The beauty of options is that you can design trades based on a more specific outlook on the market that can define levels of risk and reward.
A vertical spread involves buying and selling a call (call spread) or buying and selling a put (put spread) of the same expiration but different strikes. Vertical spread can be bullish or bearish, done with a debit or credit, but most importantly, vertical spreads allow traders to make directional bets on an underlying market with known risk and rewards.
A bear spread is any spread strategy in which the position will be profitable if the underlying stock’s market value falls. A bear spread can be designed using either puts or calls.
One example of a bear spread using puts is where a bear spread is created by selling a put with a lower strike and buying a put with a higher strike. This limits both profits and losses; however, profit occurs if and when the underlying stock’s value falls.
In a bear spread using calls, a higher short position is offset by a lower long position. For example, a bear spread is created on an underlying trading at $108.10 by buying a 120 call at 4.30 and selling a 115 call at 6.10 for a net credit of 1.80. As long as the underlying stock remains below the short position’s strike price of 115, the short call will lose value. If the stock’s price rises above the short call’s value, losses will be limited by the higher 120 call, and the dollar amount of the maximum loss will be $320 (five points difference in the strikes, minus the 1.80 credit in the position).
In this example, the greatest advantage is gained when the stock remains below $115 per share. If that occurs, maximum profit is equal to the net 1.80 points in the position.
The bear call spread is a variation of the bear spread employing only calls and creating a net credit. The profit is maximized when the market value of the underlying stocks declines; however, risk is limited to the difference between long and short positions. The spread creates a limited maximum profit potential in exchange for a limited maximum loss. A loss occurs when the stock’s price rises above both call strikes and is limited to the point spread minus the original credit received when the position was opened.
The breakeven on this position resides in between the two strike prices. Profit is equal to the amount of the net credit received. The bear call spread always creates a credit because current value of the lower short call will always exceed the value of the higher long call (see “Bear call spread,” above).
Example: The current underlying price is $78.14. A bear call spread is set up with the following trades:
Buy 13-day 79 call, ask 1.12
Sell 13-day 78 call, bid 1.30
Net credit 0.18
Bear call spread:
Stock price $78.14
Long 13-day 79 call
Short 13-day 78 call, bid 1.30
The bear put spread is a debit spread entered into when a trader thinks the underlying price is going to decline. Unlike the bear call spread, which sets up a net credit, the bear put spread creates a net debit. It combines an in-the-money long put with an out-of-the-money short put. This sets up a limited maximum profit and loss. Breakeven is equal to the higher strike minus the net debit paid (see “Bear put spread,” below).
Example: The current underlying price is $130.01. A bear put spread is set up with the following trades:
Buy 20-day 131 put, ask 2.34
Sell 20-day 129 put, bid 1.29
Net debit 1.05
Bear put spread
Stock price $130.01
Long 20-day 131 put, ask 2.34
Short 20-day 129 put, bid 1.29
The bull call spread is a variation of the vertical spread, designed to produce maximum profits when the underlying stock rises. This position involves a long call at one strike with a short call at a higher strike. If the same relative position is open but expiration is different for each side, it becomes a diagonal spread.
The bull call spread offers a combined limited profit and limited risk. Risk never exceeds the net cost to open the position, and the strategy is favored by many investors over a simple long call purchase because the cost is lower. Even so, the position always creates a net debit when both sides are opened at the same time, because the lower strike call trades at a higher price than those calls with higher strikes. One exception is if each side of the spread is opened at different times and based on stock price movement, an original long or short position is converted to a spread. In this case, it is possible to create a bull call spread with a net credit.
Net breakeven on this strategy resides between the two strike prices and is equal to the strike of the long call plus the net debit paid. A limited profit zone exists above the higher strike; this is always a fixed profit equal to the point difference between strikes, minus the cost to create the position. Maximum loss is realized if the underlying stock’s price ends up at expiration below the lower strike. The maximum loss in the position is equal to the net debit involved in opening the position (see “Bull call spread,” below).
Example: You create a bull call spread on a stock valued at $93.69 per share. You buy a 90 call at the ask price of 4.70 and sell a 95 at the bid price of 1.45.
Bull call spread:
Stock price $93.69
Long 90 call @ 4.70
Short 95 call @ 1.45
The bull put spread is a variation of a vertical spread using puts. This strategy combines a long put at one strike with a short put at a higher strike. The greatest potential profit is achieved when the stock price rises.
For example, the underlying is valued at 108.10. A bull put spread — to be used if you believe the stock price is going to rise — is constructed by buying a 105 put at the ask of 2.95 and selling a 110 put at the bid of 5.00. The net credit in this example is 2.05. The spreads between the two strikes is five points. If the stock price rises above the higher (short) strike, the maximum profit of 2.05 ($205) will be earned since both puts will expire worthless. Risk is limited as well. If the stock closes between the two put strikes, profit or loss depends on the net credit received (see “Bull put spread,” below). If the stock price closes below the lower strike, the maximum loss of 2.95 will be realized, which is the difference between the five-point spread and the net cost of the position (5.00 - 2.05).
Bull put spread:
Stock price $108.10
Short 110 put @ 5.00
Long 105 @2.95
The beauty of vertical spreads is that they can be designed to serve specific needs with a definitive risk level. It is an important tool for traders.
This article features strategies that are included in more detail in Michael Thomsett’s upcoming book “The Complete Options Trader.”