Vertical Spreads
What is a vertical spread?
A vertical spread is an options trading strategy that involves buying and selling two options of the same type (calls or puts), same underlying security, and same expiration date, but at different strike prices. The goal of a vertical spread is to limit risk while potentially reducing the cost of the trade.
Below are examples of debit spreads and credit spreads. Each example also shows a bullish and bearish scenario.
Debit Spreads
For both examples below let’s assume TSLA stock price is currently at $655 per share.
Bullish Debit Spread:
- Buy 1 TSLA 675C = -$15.5
- Sell 1 TSLA 685C = +$12.5
- Total Cost (risk): $3
- Max Gain (potential): $7 (width of spread minus total cost)
This trade is profitable if TSLA is above 678 (long call + total cost) at expiration. This trade will break even if TSLA is 678 at expiration. Max loss is realized at expiration if TSLA is below 675. Max gain is realized at expiration if TSLA is above 685.
Bearish Debit Spread:
- Buy 1 TSLA 630P = -$15
- Sell 1 TSLA 610P = +$9.5
- Total Cost (risk): $5.5
- Max Gain (potential): $14.5 (width of spread minus total cost)
This trade is profitable if TSLA is below 624.5 (long put – total cost) at expiration. This trade will break even if TSLA is 624.5 at expiration. Max loss is realized at expiration if TSLA is above 630. Max gain is realized at expiration if TSLA is below 610.
Spreads will greatly reduce the cost of putting on the position as well as reduce the impact of theta. The reason is because as the long call/put is decaying the short call/put is decaying as well. When a short contract decays it will make money, this will help to offset the decay in the long contract and reduce the negative effect of theta on the overall position. Vertical Spreads will cap potential gains at the short strike, but they will also reduce the overall risk of the position by lowering your initial cost and combating theta decay.
Credit Spreads
For both examples below let’s assume TSLA stock price is currently at $620 per share.
Bullish Credit Spread:
- Sell 1 TSLA 600P = +$14
- Buy 1 TSLA 580P = -$8.5
- Total Credit: $5.5
- Max Risk (potential): $14.5 (width of spread minus total credit)
This trade is profitable if TSLA is above 594.5 (short put – total credit) at expiration. This trade will break even if TSLA is exactly 594.5 at expiration. Max loss is realized at expiration if TSLA is below 580. Max gain is realized at expiration if TSLA is above 600.
Bearish Credit Spread:
- Sell 1 TSLA 640C = +$12
- Buy 1 TSLA 650C = -$9
- Total Credit: $3
- Max Risk (potential): $7 (width of spread minus total credit)
This trade is profitable if TSLA is below 643 (short call + total credit) at expiration. This trade will break even if TSLA is exactly 643 at expiration. Max loss is realized at expiration if TSLA is above 650. Max gain is realized at expiration if TSLA is below 640.
In both examples the goal is for the spread to remain OTM. This strategy capitalizes on Theta (time decay) and decreases in implied volatility (IV crush). The great thing about this strategy is that the underlying can go up, down, sideways, and this trade will remain profitable so long as the short contract does not go ITM deeper than the total credit received. The caveat is that the max risk is higher than the max gain and that is a direct result of there being a higher potential for the trade to work. To put on a short vertical spread, you will need to hold an amount of cash in your account equal to the max risk potential; it will be held as collateral during the trade. When the trade is executed your account will instantly be credited the total credit amount.
Frequently Asked Questions
What are the 4 vertical spreads?
The four spreads are Bull Call Spread, Bear Call Spread, Bull Put Spread, and Bear Put Spread
Are vertical spreads profitable?
Vertical spreads can be profitable depending on the movement of the underlying asset and the trader’s ability to accurately predict these movements. However, like all trading strategies, they come with risks and the potential for losses, especially if the market does not move as anticipated.