Before we go into vertical options spread, we need to understand what a spread and an option spread are. A spread is a measure of the difference between two different stocks, yields, prices, or interest rates. An option spread is purchasing two or more options of the same class and the same security but with different expiration dates or different strike prices. Many investors use options to minimize the risk and cost of entering the market trade.
There are three main types of options spreads:
- Horizontal options spread
- Diagonal options spread
- Vertical options spread
The horizontal options spread, also known as a calendar spread, is a strategy where options with different expiry dates are bought and sold but with the same strike price and security.
A diagonal options spread is a combination of both horizontal and vertical. It is a strategy where the same type of two options are bought/sold with different strike prices and different expiry dates. A diagonal spread is also known as a modified calendar spread. The only difference between a diagonal spread and a calendar spread is the different strike prices.
Vertical Options Spread
A vertical options spread is where a trader simultaneously buys and sells options of the same type with the same expiry date but different strike prices. A vertical spread can be bullish or bearish, and traders can invest in two options: a vertical call or a vertical put option. Remember that you have to sell a call option with the same expiration if you buy a call option. You cannot interchange between call and put options. There are two options within the call and put vertical spreads: debit and credit.
A debit spread seeks to gain maximum profit. It results from when a trader buys an option with a high premium and sells an option with a low premium. The difference between the two is called the net debit, also known as the debit spread. A trader will make a profit when the premium between the two options widens from each other.
When the option is sold at a higher price than the option bought, it is a credit spread. This difference creates a net credit. Investors use vertical option credit spreads to lower the option’s risks.
There are four basic types of vertical options spread:
- Bull Call Strategy
- Bull Put Strategy
- Bear Call Strategy
- Bear Put Strategy
Bull Call Spread
A bull call spread is also known as a debit spread and a long call spread. To trade a bull call spread, you should buy a call option and sell a call option at a higher price. You should only buy a call spread if you believe that the stock’s price will moderately increase. It is mainly used at times of high volatility.
An example of a bull call spread:
A trader buys a call option for a premium of $12 at a strike price of $150. The trader simultaneously sells a call option at a premium of $8 and a strike price of $190.
- Net commission is $12 – $8 = $4
- The maximum profit = $190 – $150 – $4 = $36
- Maximum loss = $4
- Break-even point = $150 + $4 = $154
If the stock price falls below the lower strike price, both calls become worthless, and the trader will lose the premium paid.
If you want to learn more about this strategy, you can read it on the MarketXLS website – https://marketxls.com/bull-call-spread-option-strategy/
MarketXLS has a template that helps investors decide when to buy/sell stocks. Here is the link to the template – Bull Call Spread Option Strategy
Bull Put Spread
A bull put spread is an options strategy that involves buying an out-of-the-money put option at a lower strike price and selling an in-the-money put option at a higher strike price. Investors use this strategy when they know that the stocks of a company are going to rise moderately.
An example of a bull put spread:
A trader decides to buy a put option for a premium of $25. The option’s strike price is $160 and expires in September 2021. Simultaneously, the investor sells a put option for a premium of $55. This option expires in September 2021, and the strike price is $200.
- Trader’s cash inflow/ Maximum gain = $55 – $25 = $30.
- The maximum loss = $200 – $160 – $30 = $10.
- The break-even point = $200 – $30 = $170.
It is beneficial to sell bull put spreads during a period of high volatility because options become expensive, and the trader can earn a higher premium. A bull put spread gives lower rewards but has a higher probability of succeeding, while a bull call spread has a higher reward but a low probability of succeeding.
If you want to learn more about this strategy, you can read it on the MarketXLS website – Bull Put Spread
Here is the link to the template – Bull Put Spread Option Strategy
Bear Call Spread
The bear call spread consists of a short call with a lower strike price than the long call’s strike price. This spread creates a net credit for the trader. It will be beneficial for the trader if the stock closes below the lower strike price because this strategy only profits if the stock stays steady or declines. This strategy has limited risk and limited profit.
An example of the bear call spread:
An investor decides to buy a call option with a strike price of 50 for a premium of $200. At the same time, the investor decides to sell a call option with a strike price of 40 for a $350 premium.
- The investor earns a net credit of $350 – $200 = $150.
- If the stock price closes at 35, the investor gets the full premium of $150.
- Stock closes at 55, the investor makes a loss.
If you want to learn more about this strategy, you can read it on the MarketXLS website – Bear Call Options
Here is the link to the template – Bear Call Spread Option Strategy
Bear Put Spread
The bear put spread involves buying a higher strike price put option and selling a lower strike price put option simultaneously. Again, to be profitable, we need the stock price to decline. A bearish investor who wants to minimize loss and maximize profit should use this options strategy.
An example of a bear put spread:
Suppose a stock is trading at $45 and a trader purchases a put option at a strike price of $47 for a cost of $400. The trader then sells a put option at a strike price of $43 for a cost of $250.
- The trader has to pay a net debit of $150.
- If the stock price rises to $50, then the trader would lose the net debit of $150.
- If the price closes on $41, the trader will gain a profit of $250.
The bear put spread also has limited risk, and it limits profit to the difference between strike prices. The lower the short put strike price, the higher the amount of profit earned minus the cost of the premium paid. Shifts in volatility can affect the two option prices to a great extent.
A bear put spread is a net debit while a bear call spread is a net credit. Traders invest in the bearish options strategies when they know the stock prices are going to decline moderately.
If you want to learn more about this strategy, you can read it on the MarketXLS website – Bear Put Options
Here is the link to the template – Bear Put Spread Option Strategy
The Bottom Line
It is essential to know which vertical options spread to use as it helps increase your chances of successful trading. MarketXLS allows investors to monitor the maximum profit and loss at different strike prices so they can choose the best option. MarketXLS has templates for all four of these vertical options spread strategies. Feel free to check them out through the links.
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