April 15, 2024

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Which Vertical Option Spread Should You Use?

6 min read
Spread Strategy Strike Prices Debit / Credit Max. Gain Max. Loss Break-Even
Bull Call Buy Call C1
Write Call C2
Strike price of C2 > C1 Debit (C2 − C1) − Premium paid Premium paid C1 + Premium
Bear Call Write Call C1
Buy Call C2
Strike price of C2 > C1 Credit Premium received (C2 − C1) − Premium received C1 + Premium
Bull Put Write Put P1
Buy Put P2
Strike price of P1 > P2 Credit Premium received (P1 − P2) − Premium received P1 − Premium
Bear Put Buy Put P1
Write Put P2
Strike price of P1 > P2 Debit (P1 − P2) − Premium paid Premium paid P1 − Premium

Credit and Debit Spreads

Vertical spreads are used for two primary reasons:

  1. To reduce the premium amount payable (debit spreads).
  2. To lower the option position’s risk (credit spreads).

Reduce Premium Cost

Let’s evaluate the first point. Option premiums can be quite expensive when overall market volatility is elevated, or when a specific stock’s implied volatility is high. While a vertical spread caps the maximum gain that can be made from an option position, compared to the profit potential of a stand-alone call or put, it also substantially reduces the position’s cost.

Thus, such spreads can be used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg.

Lower Risk

As far as credit spreads are concerned, they can greatly reduce the risk of writing options, since option writers take on significant risk to pocket a relatively small amount of option premium. One disastrous trade can wipe out positive results from many successful option trades. In fact, option writers are occasionally disparagingly referred to as individuals who stoop to collect pennies on the railway track. They happily do so—until a train comes along and runs them over.

Writing naked (uncovered) calls is among the riskiest option strategies, since the potential loss if the trade goes awry is theoretically unlimited. Writing puts is comparatively less risky, but an aggressive trader who has written puts on numerous stocks would be stuck with a large number of pricey stocks in a sudden market crash. Credit spreads mitigate this risk, although the cost of this risk mitigation is a lower amount of option premium.

Which Vertical Spread to Use

Bull Call Spread

Consider using a bull call spread when calls are expensive due to elevated volatility and you expect moderate upside rather than huge gains. This scenario is typically seen in the latter stages of a bull market, when stocks are nearing a peak and gains are harder to achieve.

A bull call spread can also be effective for a stock that has great long-term potential but elevated volatility due to a recent plunge.

Bear Call Spread

Consider using a bear call spread when volatility is high and a modest downside is expected. This scenario is typically seen in the final stages of a bear market or correction, when stocks are nearing a trough but volatility is still elevated because pessimism reigns supreme.

Bull Put Spread

Consider using a bull put spread to earn premium income in sideways to marginally higher markets, or to buy stocks at reduced prices when markets are choppy. Buying stocks at reduced prices is possible because the written put may be exercised to buy the stock at the strike price. The credit received reduces the cost of buying the shares (compared to if the shares were bought at the strike price directly). 

This strategy is especially appropriate to accumulate high-quality stocks at cheap prices when there is a sudden bout of volatility but the underlying trend is still upward. A bull put spread is akin to “buying the dips,” with the added bonus of receiving premium income in the bargain.

Bear Put Spread

Consider using a bear put spread when a moderate to significant downside is expected in a stock or index and volatility is rising. Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid. For example, if you’re seeking to hedge long positions after a strong bull market.

There is always a trade-off. Before establishing a spread trade, consider what you give up or gain by choosing different strike prices. Consider the probabilities that the maximum gain will be attained or that the maximum loss will be taken. While it is possible to create trades with high theoretical gains, if the probability of that gain is minuscule, and if the likelihood of losing is high, then consider a more balanced approach.

Factors to Consider

The following factors may assist you in coming up with an appropriate options/spread strategy for existing conditions and your outlook on the market.

  • Bullish or bearish: Are you positive or negative on the markets? If you are very bullish, then you might be better off considering stand-alone calls (not a spread). But if you are expecting a modest upside, then consider a bull call spread or a bull put spread. Likewise, if you are modestly bearish or want to reduce the cost of hedging your long positions, then the bear call spread or bear put spread may be the answer.
  • Volatility view: Do you expect volatility to rise or fall? Rising volatility may favor the option buyer, which favors debit spread strategies. Declining volatility improves the odds for the option writer, which favors credit spread strategies.
  • Risk versus reward: A preference for limited risk with potentially greater reward is more an option buyer’s mentality. If you seek limited reward for possibly greater risk, this is more in line with the option writer’s mentality.

Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, then the best strategy would be a bear put spread.

Conversely, if you are moderately bullish, think volatility is falling, and are comfortable with the risk-reward payoff of writing options, then you should opt for a bull put spread.

Which Strike Prices to Choose

The table above outlined whether the bought option is above or below the strike price of the written option. Which strike prices to use depends on a trader’s outlook on the market.

For example, with a bull call spread, if the price of a stock is likely to stay around $55 until the options expire, then you may buy a call with a strike near 50 and sell a call at the 55 strike. If the stock is unlikely to move much, then selling a 60-strike call makes a bit less sense because the premium received will be lower. Buying a call with a 52 or 53 strike would be cheaper than buying the 50-strike price call, but there is greater downside protection with the lower strike.

Who Is a Vertical Spread for?

Vertical spreads are useful to options traders who want to benefit from specific directional market moves and also limit their financial risk.

Is a Vertical Spread a Hedge?

Yes, you’re hedging your bet by buying and selling the same option type. You’re taking positions on both sides of the market so that, while you hope to make money on one side, the other side protects you from the risk of losing too much money if the market moves contrary to your outlook. While useful, the downside of a hedge is that any profit gained from one position is reduced by the loss from the other.

Why Is the Spread Referred to As Vertical?

The term “vertical” refers to the higher and lower strike prices. One is above, the other is below. A spread can be horizontal, where the strike prices are the same but the expiration dates are different.

The Bottom Line

A vertical option spread is the simultaneous purchase and sale of the same option type (a call or a put) with the same expiration date but with different strike prices.

Understanding which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.

Look at current market conditions and consider your own analysis. Before pulling the trigger on a trade, determine which vertical spread, if any, best suits the situation and then consider which strike prices make the most sense.

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