Vertical Option Spreads

A vertical option spread is established by buying 1 option and selling another option of the same type, either calls or puts, with the same underlying security, and having the same expiration date. Only the strike price is different. Vertical spreads allow a trader to earn modest profits with less risk than buying a naked option and with considerably less risk than selling a naked option. Vertical spreads are generally used when the market has a directional bias, but where the underlying security is not expected to change significantly in price over the term of the options. Vertical spreads can also be combined with other strategies.

There are 3 ways to characterize vertical spreads: bull or bear, credit or debit, call or put. A bull spread is one that profits when the market rises; a bear spread profits when the market declines. With a credit spread, the trader receives money for entering into the transaction, while money must be paid to enter a debit spread. A credit spread earns a premium because the option that is sold has a strike price closer to the current price of the underlying security, while the bought option is more out-of-the-money, and, therefore, cheaper. In a debit spread, the out-of-the-money option is sold, while the in-the-money or at-the-money option is bought. A call or put spread is simply one that uses calls or puts, respectively. Generally, calls increase in value when the market rises, while puts increase in value when the market declines. However, with a vertical spread, it is possible to make money with either calls or puts in both rising and declining markets, which is why spreads are further characterized as being either call or put spreads.

The names of the different vertical option spreads can be confusing, but such confusion can be avoided if you understand the meaning of each term in regards to the spread. The best way to think about these vertical spreads is to consider the wording. The 1st word — bull and bear – is the direction that the underlying stock must move to make the spread profitable. Thus, a bull spread is undertaken with the expectation that the underlying stock will rise in price, while a bear spread is undertaken with the expectation that the underlying will decline in price. The 2nd word designates whether the vertical spread involves either calls or puts.

To simplify the following discussion, the math will be related to a single share of the underlying security. However, keep in mind that each call or put option traded on exchanges in the United States usually represents 100 shares of the underlying security; on European exchanges, a call or put may represent 1000 shares. Obviously, any profits or losses calculated with a single share must be multiplied by the number of shares represented by each option contract multiplied by the number of contracts. Transaction costs will also lower profits or increase losses. For more background information, see Stock Options, an Illustrated Introduction with Examples.

Debit Spreads

Debit spreads are so-called because the trader must pay out cash for the spread, because the option being bought costs more than the option being sold. A debit spread has no margin requirement because the greatest possible loss is equal to the cost of the debit, which must be paid when the debit spread is undertaken. There are 2 types of debit spreads:

Bull Call Spread

A bull call spread is purchased when the underlying stock or other security is expected to increase in price. A call is bought at a lower strike price while the higher strike price call is sold. So, for instance, if you bought a call with a strike price of 25 and sold a call with a strike price of 30, that would be a bull call spread. Because the lower strike call is more expensive than the sold call, the bull call spread is also a debit spread. The maximum profit is equal to the difference in the strike prices minus the premium paid to establish the spread. So if you buy a call for $5 and sell another call for $2, then the most that you can lose is $3 per call times the number of shares in each contract, multiplied by the number of call contracts bought or sold.

Bull Call Debit Spread Profit/Loss
Stock Price Profit/Loss
S ≤ K1= 0 – DebitMaximum loss: all options expire worthless.
K1 < S < K2= S – K1 – DebitThe value of the spread increases by $1 for each $1 increase in the underlying.
S ≥ K2= K2 – K1 – DebitMaximum profit: The long and short calls offset each other for stock prices ≥ high call strike.
  • S = Stock Price
  • K1 = Lower Long Call Strike
  • K2 = Higher Short Call Strike
Example: Bull Call Debit Spread for Microsoft on July 15, 2014
Stock Price$42.45
September, 2014 Calls
Strike Price
Buy K142-$1.42
Sell K244$0.63

Total Debit$0.79
Maximum Loss$0.79=Total Debit
Maximum Profit$1.21
A line chart showing the potential profit/loss of a bull call debit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
A line chart showing the potential profit/loss of a bull call debit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
MSFT closed at 47.52 on the September expiration date, yielding the maximum profit of $1.21.

A bull call spread would not be used if the underlying was expected to zoom in price, since much greater profits could be earned by simply being long on the call. However, if the stock is only expected to increase moderately, then the bull call spread is a good way to profit from the moderate price increase while limiting downside risk. If the higher call expires worthless but the lower call is in the money, then you must exercise the option and sell the stock to realize your profit; otherwise, the stock may decline in price after the expiration date.

Bear Put Spread

The bear put spread is much like the bull call spread except that the trader buys the higher strike put and sells the lower strike put, resulting in a net debit because the higher strike put, which will be more in the money, will obviously be more expensive than the lower strike put. The spread would be an effective means to profit from a moderate decline in the price of the underlying while limiting downside risk. Like the bull call spread, the maximum profit will be equal to the difference in the strike prices minus the net debit of entering into the spread. The maximum loss will be equal to the cost of the put minus the sales price of the sold put — the vertical spread premium. The breakeven point is reached when the underlying security price is equal to the higher strike price minus the cost of the spread. If the price of the underlier drops below the lower strike price, then you will be assigned the put at the lower strike price, but you will be able to exercise the put that you have bought.

Bear Put Debit Spread Profit/Loss
Stock Price Profit/Loss
S ≤ K1= (K2 – K1) – DebitMaximum profit: The long and short puts offset each other for stock prices ≤ low put strike.
K1 < S < K2= (S – K1) – DebitThe value of the spread decreases by $1 for each $1 increase in the underlying.
S ≥ K2= DebitMaximum loss: all options expire worthless.
  • S = Stock Price
  • K1 = Lower Short Put Strike
  • K2 = Higher Long Put Strike
Example: Bear Put Debit Spread for Microsoft on July 15, 2014
Stock Price$42.45
September, 2014 Puts
Strike Price
Sell K142$1.28
Buy K244-$2.55

Total Debit$1.27
Maximum Loss$1.27= Debit
Maximum Profit$0.73
A line chart showing the potential profit/loss of a bear put debit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
A line chart showing the potential profit/loss of a bear put debit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
MSFT closed at 47.52 on the September expiration date, yielding the maximum loss of $1.27.

Credit Spreads

A credit spread is so-called because there is a net credit when establishing a credit spread, because the more in-the-money option is sold and a more out-of-the-money option is bought. The maximum profit equals the credit spread premium, equal to the higher priced sold option minus the lower priced bought option. However, the risk of the trade must be offset with posted margin.

Margin Requirement for Credit Spread = Upper Strike – Lower Strike – Credit

So if a call with a strike price of $25 is sold while a call with a strike of $30 is bought, and the credit received is $2, then the margin requirement = $30 – $25 – $2 = $3, so $300 of margin would have to be posted for each spread involving 100-share contracts.

Greater differences in strike prices have a greater profit potential, but also greater risk. There are 2 types of credit spreads: the bull put spread and the bear call spread. As with all spreads, the advantage of the credit spread is that the risk is more limited but at the cost of a limited potential profit.

Bull Put Spread

A bull put spread profits when the underlying security increases in price. Sell the higher strike put and buy the lower strike put, when the underlier is expected to go higher. So if the underlier rises above the higher strike put, then both puts expire worthless, and you earn the credit spread as your maximum profit. The breakeven point will be equal to the higher strike minus the credit spread, so if the higher strike put has a strike of $55 and the credit is equal to $2, then the breakeven point will be reached when the underlying reaches $55 – $2 = $53.

Bull Put Credit Spread Profit/Loss
Stock Price Profit/Loss
S ≤ K1= Credit – (K2 – K1)Maximum loss: The long and short puts offset each other for stock prices ≤ low put strike.
K1 < S < K2= Credit – (K2 – S)The value of the spread increases by $1 for each $1 increase in the underlying.
S ≥ K2= CreditMaximum profit: all options expire worthless.
  • S = Stock Price
  • K1 = Lower Long Put Strike
  • K2 = Higher Short Put Strike
Example: Bull Put Credit Spread for Microsoft on July 15, 2014
Stock Price$42.45
September, 2014 Puts
Strike Price
Buy K142-$1.28
Sell K244$2.55

Total Credit$1.27
Maximum Loss$0.73
Maximum Profit$1.27= Credit
A line chart showing the potential profit/loss of a bull put credit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
A line chart showing the potential profit/loss of a bull put credit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
MSFT closed at 47.52 on the September expiration date, yielding the maximum profit of $1.27.
A bull spread profits when the underlying stock increases in price. The bull call debit spread earns a maximum of the difference in strike prices minus the debit. A bull put credit spread earns the maximum profit from the credit when both options expire worthless. Note that the basic graph is the same for both spreads.
Diagram of a bull call debit spread and a bull put credit spread.

Bear Call Spread

The bear call spread is undertaken when the price of the underlying is expected to decline. The call spread is established by selling a short lower call position and buying a long call position at a higher strike to limit risk. The maximum profit will be realized if the stock drops below the lower call strike with the result that both call options expire worthless and you get to keep the credit.

Since a call with a lower strike price is sold, the sales proceeds will be more than the cost of the higher strike call, since the lower call has a greater chance of being in the money at expiration. The maximum loss will be equal to the difference in strike prices minus the spread credit. The breakeven point will be the lower strike price plus the premium collected for the credit spread.

Bear Call Spread Profit/Loss
Stock Price Profit/Loss
S ≤ K1= CreditMaximum profit: all options expire worthless.
K1 < S < K2= Credit – (S – K1)The value of the spread decreases by $1 for each $1 increase in the underlying.
S ≥ K2= Credit - (K2 – K1)Maximum loss. The long and short calls offset each other for stock prices ≥ high call strike.
  • S = Stock Price
  • K1 = Lower Short Call Strike
  • K2 = Higher Long Call Strike
Example: Bear Call Credit Spread for Microsoft on July 15, 2014
Stock Price$42.45
September, 2014 Calls
Strike Price
Sell K142$1.42
Buy K244-$0.63

Total Credit$0.79
Maximum Loss$1.21
Maximum Profit$0.79= Credit
A line chart showing the potential profit/loss of a bear call credit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
A line chart showing the potential profit/loss of a bear call credit spread for Microsoft at options expiration for underlying stock prices ranging from $40 to $46.
MSFT closed at 47.52 on the September expiration date, yielding the maximum loss of $1.21.
A bear spread profits when the underlying stock decreases in price. The bear call spread earns the maximum profit from the credit when both options expire worthless. A bull put debit spread earns a maximum of the difference in strike prices minus the debit. Note that the basic graph is the same for both spreads.
Diagram of a bear call credit spread and a bear put debit spread.

The terms for vertical spreads can be lengthy and confusing, so most traders simplify their terminology for referring to the various spreads. A debit spread is referred to as buying a spread, because it costs money to establish a position, whereas a credit spread is referred to as selling a spread, since a credit is received for establishing the position. So a bull call debit spread would be referred to as a buying a call spread whereas the bear call credit spread would be referred to as selling a call spread; likewise for put spreads.

Choosing a Vertical Spread

Generally, a vertical spread is chosen so as to maximize profits for small changes in the price of the underlying, while also limiting risk. Since, over the terms of most options, the underlying price changes little, the price of the long option can be offset by the sale of the short option. While this also limits potential profits, it is rare that the price of the underlying will zoom in one direction or the other over a short time span, so, in these cases, profit can be increased a little by the sale of the short option. If the price of the underlying is expected to zoom in 1 direction or another, then it makes sense to buy a long call if the underlying is expected to zoom up or buy a long put if it is expected to zoom down. If you decide that a vertical spread is the best strategy because you only expect modest increases or decreases in the price of the underlying, then 1 way to narrow the selection of a vertical spread is by only considering option pairs where the short option price is a significant percentage of the long option price; otherwise, there would be no point in limiting potential profits for a long position by selling the short option.

The decision on which vertical to trade will depend on which security is selected and where the underlying security is expected to move within the term of the options. The goal of any spread is to maximize the potential profit while minimizing the potential risk, and this will be largely determined by the stock price when the spread is undertaken and what the stock price is expected to be at expiration. The selected time horizon will also be important when considering the best strategy. Keep in mind that the time value of an option decays fastest during the last month of the option term. For debit spreads, longer time horizons are preferable, whereas faster time decays will benefit credit spreads.

For a debit spread, you would buy the option that is closest to the underlying price and you would sell the option that is nearest to where you believe the underlying will be at expiration, since this will yield the maximum profit, equal to the difference in the strike prices minus the debit. For credit spreads, you should buy the strike price for where you believe the underlying security will be at expiration and sell the strike price that is closest to the underlying at the time the spread is undertaken; if your prediction is correct, then both options will expire worthless and you will earn the maximum profit of the credit.

Comparing Vertical Spreads
Vertical Spread Maximum
Profit
Maximum
Loss
Bull Call Debit Spread$1.21$0.79
Bear Call Credit Spread$0.79$1.21
Bear Put Debit Spread$0.73$1.27
Bull Put Credit Spread$1.27$0.73

To illustrate the selection process, the above table summarizes the maximum profit and loss for each type of vertical spread for Microsoft, using the same strike prices in all 4 spreads. As you can see, the 2 call spreads are inversions of each other, with the maximum profit of the bull call spread equal to the maximum loss of the bear call spread, and the maximum loss of the bull call spread is equal to the maximum profit of the bear call spread; likewise for the put spreads. Although the profits and losses of each spread are equitable, if the price of the underlying is expected to increase, then only the bull spreads should be considered, in which case, the bull put credit spread offers both the maximum profit and the minimum loss over the bull call debit spread, so it only makes sense to select the bull put spread for the chosen strike prices. If the price of the underlying is expected to decline, then only the bear spread should be considered, in which case, the bear call credit spread offers the maximum profit and the minimum loss over the bear put debit spread. Hence, the best combination can be found by 1st considering whether a bull or bear spread is needed, then selecting the available strike prices that will yield the maximum profit with the minimum risk.

Further consideration must be accorded to bid/ask spreads, since wide bid/ask spreads may eliminate or greatly reduce the profit potential of some vertical spreads. In-the-money options tend to have higher bid/ask spreads, especially since the higher deltas of ITM options will create more volatility.

Update: Microsoft closed at $47.52 on September expiration (9/19/2014). Therefore, the maximum profit of $1.27 was made by the bull put credit spread, which also had the lowest maximum loss.