Vertical Spreads – The Secret to Successful Trades

As an option trader, vertical spreads are most likely an integral part of your arsenal as a swing trader and if they are not, they should be. What makes them so worthy of your consideration is the wide variety of risk/reward and probability scenarios depending on an option trader’s outlook.

Vertical spreads can be extremely versatile and represent a major building block of more complex spreads. With a vertical spread, the various strike prices for an option are arranged vertically and the expirations available to trade are displayed horizontally. This defined risk position consists of both a long and short position at different strike prices within the same expiration. It can be constructed with either puts or calls, and the initial cash flow can be either a credit or debit. Strike prices can be selected to produce either aggressive or conservative stances depending on the outlook and the risk/reward that is desired. Let’s take a look below.

Vertical Debit Spreads

There are two vertical debit spreads: bull call and bear put spread. Generally, these spreads are implemented around-the-money when a bullish or bearish move is expected. For a bullish outlook, an option trader might consider a bull call. A bull call is when a call option is bought (usually around-the-money) and a higher strike call is sold with the same expiration. Maximum loss is limited to the cost of the spread and realized if the underlying is trading at or below the long call strike at expiration. Maximum profit is the difference in the strikes minus the cost of the spread. This is realized if the underlying is trading at or above the short call strike at expiration. Breakeven for the position is the long call strike plus the cost of the spread.

For a bearish outlook, an option trader might consider a bear put. A bear put is when a put option is bought (usually around-the-money) and a lower strike put is sold with the same expiration. Maximum loss is limited to the cost of the spread and realized if the underlying is trading at or above the long put strike at expiration. Maximum profit is the difference in the strikes minus the cost of the spread. This is realized if the underlying is trading at or below the short call strike at expiration. Breakeven for the position is the long put strike minus the cost of the spread.

Vertical Debit Spread Example

An option trader is looking at a chart and sees that a stock is trading above a resistance level and thinks it may move higher over the next couple of weeks. The stock is currently trading at $60 and he thinks it may get to $70 in that time. He could buy a 60 call with 2 weeks till expiration for a 7.00 debit and sell a 70 call with the same expiration for a credit of 3.00. The cost of the trade would be 4.00 (7 – 3). That is the total risk of the position and the maximum loss would be realized if the stock closed at $60 or lower at expiration (both calls would expire worthless). Maximum profit would be the difference in the strikes 10 (60 – 50) minus the cost of the trade or 6.00 (10 – 4.00). Maximum profit would be realized if the stock was trading at or above $70 at expiration. Breakeven is $64 (60 (long call strike) + 4 (cost of the spread)).

Vertical Credit Spreads

There are two vertical credit spreads: bull put and bear call spread. Generally, these spreads are implemented out-of-the-money when a bullish, bearish or neutral move is expected. Since they are generally implemented out-of-the-money, the underlying doesn’t necessarily have to move directionally to profit. For a bullish or neutral outlook, an option trader might consider a bull put. A bull put is when a put option is sold (usually out-of-the-money) and a lower strike put is bought with the same expiration. Maximum gain is limited to the credit received from the spread and realized if the underlying is trading at or above the short put strike at expiration (both puts expire worthless). Maximum loss is the difference in the strikes minus the credit received from the spread. This is realized if the underlying is trading at or below the long put strike at expiration. Breakeven for the position is the short put strike minus the credit received from the spread.

For a bearish or neutral outlook, an option trader might consider a bear call. A bear call is when a call option is sold (usually out-of-the-money) and a higher strike call is bought with the same expiration. Maximum profit is limited to the credit received from the spread and realized if the underlying is trading at or below the short call strike at expiration (both calls expire worthless). Maximum loss is the difference in the strikes minus the credit received from the spread. This is realized if the underlying is trading at or above the long call strike at expiration. Breakeven for the position is the short call strike plus the credit received from the spread.

Vertical Credit Spread Example

An option trader sees an area on a chart that the stock has come down to several times over the past several months and each time has rallied higher from that level. He considers that level to be potential support for the stock. The stock is currently trading at $105 and he thinks it will stay above that potential support level which is right around $100. He could sell a 100 put with 1 week till expiration for a 3.00 credit and buy a 95 put with the same expiration for a debit of 1.50. The credit received would be 1.50 (3 – 1.50). That is the max profit of the position and it would be realized if the stock closed at $100 or higher at expiration (both puts would expire worthless). Maximum loss would be the difference in the strikes 5 (100 – 95) minus the credit received or 3.50 (5 – 1.50). Maximum loss would be realized if the stock was trading at or below $95 at expiration. Breakeven is $98.50 (100 (short put strike) – 1.50 (credit of the spread)).

Why Expiration and Strike Prices Are Important

Vertical credit spreads are often sold out-of-the-money (OTM). In other words, the trader thinks the stock will stay above or below a certain area. For example, with the stock at $85, the trader believes the stock will at least trade above $80. The trader can sell an 80 put and buy a 75 put. The trade benefits if the stock moves higher or time passes (theta). Theta measures the decline of an option’s value through the passing of time. Max profit is earned if the stock closes at $80 or higher at expiration. In effect, the stock has three out of four ways to profit: a move higher, trading sideways or even a move lower.

The further away the vertical credit spread is from where the underlying is trading, the more wiggle room you have but the worse risk/reward as well. The closer to the underlying, the less wiggle room but the better risk/reward. The same is true of expiration. The shorter the expiration, the smaller credit received and bigger risk. Delta will be bigger and positive theta too when OTM. A longer expiration will yield a bigger credit, which means smaller risk but also smaller delta and positive theta.

Final Thoughts

Choosing strike prices and expirations are important for vertical debit spreads too since they are synthetically the same as vertical credit spreads. The thing is, most option traders don’t think about it as much as they do with vertical credit spreads. The key to vertical spreads is when and how to use them effectively. Having them in an option trader’s arsenal is a must.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

6 replies on “Vertical Spreads – The Secret to Successful Trades”

Hello Michael and Ernie

I agree, verticals are great. However, I miss in your treatise the case where the underlying closes between the strikes. Then the short leg will be assigned, but the long leg not executed.

It is not totally improbable that after the spread has expired, the underlying makes a gap down and the loss is no longer limited as always

Kind regards
Chrys

Hey Chris. This is Dan (we have no Earnie or Michael here). Really great points. One thing to consider, we teach our flock to close out trades before expiration, which will help a lot avoid options assignment.

I agree Dan. I like to close my OOM credit spreads for a penny before expiration just to avoid the risk that Chris notes. Especially true for higher priced underlyings where assignment risk can be especially expensive, or when you have a large number of contracts. However if it is a manageable number of contracts and one is ok with being put to for put credit spreads then maybe I will let a solidly OOM spread expire worthless and not give back the penny. Does this make sense?

Ron, we typically look at volatility. Both in the sense of: Are we expecting a move to a target (best for debit spreads) or just not a lot of movement (best for credit spreads); as well as high IV (best for credit spreads) or low IV (best for debit spreads).

Hey Dan
thank you very much for your reply 😉
That’s why I always try to close my verticals before they expire but sometimes this means to realize losses.
(we have no Earnie or Michael here). – I got a little mixed up and apologize for this confusion 🙁

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