Vertical Spread

Vertical Spread: Definition and Overview

A vertical spread is an options strategy that involves simultaneously buying and selling two options of the same type (both calls or both puts), with the same expiration date but different strike prices. Traders use vertical spreads to express a directional view when they expect a moderate move in the underlying asset. These strategies limit both downside risk and upside reward compared with buying or selling naked options.

Why Use Vertical Spreads

• Lower cost and lower risk than naked options: the premium received from selling one leg offsets the cost of buying the other.
• Defined, limited risk and reward make position sizing and risk management straightforward.
• Useful when you expect a moderate (not large) move in the underlying asset.
• Can be structured as either a net debit (pay to enter) or a net credit (receive to enter), depending on the strikes and option types.

Types of Vertical Spreads

Vertical spreads are categorized by market view (bullish or bearish) and by option type (calls or puts).

Bullish strategies
* Bull call spread (call debit spread)
– Structure: Buy a call at a lower strike, sell a call at a higher strike (same expiry).
– Typical cash flow: net debit (you pay to enter).
* Bull put spread (put credit spread)
– Structure: Sell a put at a higher strike, buy a put at a lower strike.
– Typical cash flow: net credit (you receive premium).

Bearish strategies
* Bear call spread (call credit spread)
– Structure: Sell a call at a lower strike, buy a call at a higher strike.
– Typical cash flow: net credit.
* Bear put spread (put debit spread)
– Structure: Buy a put at a higher strike, sell a put at a lower strike.
– Typical cash flow: net debit.

Profit, Loss, and Breakeven (Ignoring Commissions)

Let K1 = lower strike, K2 = higher strike. Define “net premium paid” as premiums paid minus premiums received (positive for net debit). Define “net premium received” as premiums received minus premiums paid (positive for net credit).

Bull call spread (net debit)
* Max profit = (K2 − K1) − net premium paid
* Max loss = net premium paid
* Breakeven = K1 + net premium paid

Bear call spread (net credit)
* Max profit = net premium received
* Max loss = (K2 − K1) − net premium received
* Breakeven = K1 + net premium received

Bull put spread (net credit)
* Max profit = net premium received
* Max loss = (K2 − K1) − net premium received
* Breakeven = K2 − net premium received

Bear put spread (net debit)
* Max profit = (K2 − K1) − net premium paid
* Max loss = net premium paid
* Breakeven = K2 − net premium paid

Example: Bull Call Spread

Stock XYZ = $50.
Strategy: buy a 45-call for $4 (pay $4), sell a 55-call for $3 (receive $3). Net premium paid = $1 (a $1 net debit). Strike spread = $10.

• Max profit = $10 − $1 = $9.
• Max loss = $1 (net premium paid).
• Breakeven = 45 + $1 = $46.

If at expiration the stock is $49:
* The long 45-call is worth $4; the short 55-call expires worthless.
* Spread value = $4. Profit = spread value − net premium paid = $4 − $1 = $3.

Key Takeaways

• Vertical spreads are directional, limited-risk strategies for moderate price moves.
• They use two options of the same type and expiration but different strikes.
• Some verticals are entered for a net debit (pay to open) and others for a net credit (receive to open).
• Profit and loss are capped and easy to calculate using strike differences and net premiums.
• Choose vertical spreads when you want to define risk and cost while expressing a bullish or bearish view without expecting a large, trend-like move.