Vertical Option Spreads

Table of Contents
Chapter 1: What are Option Spreads
Chapter 2: Vertical Option Spreads
Chapter 3: Calendar Option Spreads
Chapter 4: Diagonal Option Spread
Chapter 5: Trading Options with Spreads

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Chapter 2: Vertical Spreads
– Vertical Bull Call Debit Spread
– Vertical Bear Put Debit Spread
– Vertical Bear Call Credit Spread
– Vertical Bull Put Credit Spread

Chapter 2: Vertical Option Spreads

A vertical spread involves a strategy where you buy two options of the same underlying and with the same expiry date, but with different strike prices. The example that we discussed in the last section was a vertical spread. The name for these spreads comes from the trading sheets that were used on the trading floor.

Prices for different options of the same stock were mentioned one after the other on the sheet, ordered by expiry date and stock price. Thus a trader had to vertically compare the prices of two options that he wanted to use to create a vertical spread.

A straightforward vertical spread is created when you buy an out of the money call on a stock and counter-balance it by selling a further out of the money call option. As we saw in the previous example, this is a bullish strategy where you are hoping for the stock price to go up. Such a spread is referred to as a bull call debit spread and you are said to have a positive position delta trade.

A positive position delta shows that your position will gain when the price of the underlying goes up. This happens because when you combine the two options, taking opposing views, the delta is not always neutralized completely. The two options have different deltas – the OTM option has a higher delta as it is closer to the money and the FOTM has a lower (and negative as you are selling it) delta as it is further away from the money.

This means that when the underlying goes up, your OTM option gains more in value than that lost by your FOTM option. This mismatch helps a trader make money while keeping risks low. Of course, the returns will also be lower than what you would gain if your outright option strategy turns out to be correct, but the kind of control that a spread offers is difficult to match.

You can also see a spread as a conservative investing strategy but with a much higher leverage than what you would get in other low risk investing options. This is one of the key attractions of spreads, as most other means of increasing your leverage – futures, outright options, forex etc – can be highly risky and are not advised for an average investor looking for moderate gains.

Vertical spreads can be further categorized as debit spreads and credit spreads. Their names come from the impact that they have on your trading account when you open a spread position. With a debit spread, you will have a net debit in your account, i.e. some funds will be taken out from the account.

On the other hand, a credit spread leaves a net credit in your account, i.e. funds will be deposited into your account. Within debit and credit spreads, you can create similar (though not completely identical) strategies using either call options or put options.

Vertical Bull Call Debit Spread

To understand the complex terminology used in option spreads, you need to break the terms into pieces. A vertical bull call debit spread has the following features:

• It is a vertical spread, i.e. it is based on a single underlying and with the same expiry date but with different strike prices.
• It signifies a bullish strategy, i.e. you are expecting the price of the underlying security to move up. When you have a bearish strategy, expecting the price of the underlying to go down, the spread will be referred to as a bear spread.
• It is constructed using two call options. Similarly, put spreads are constructed using two put options.
• It leaves a debit entry in your account.

Let’s consider an example to better understand how a vertical bull call debit spread works. Let’s say the spot price of stock A is $100 on August 15. You can create the first leg of a vertical bull call debit spread by buying an out of the money call with, say, $105 as the strike price, $4 as premium, and expiry for September. The second leg can be created by selling a further out of the money call with, say, $110 as the strike price, $2 as premium, and again a September expiry.

When you create this spread, the immediate impact on your account is that you pay $400 as premium (for a lot of 100) and collect $200 as premium. Thus, your account is debited $200, and your net position from the trade is currently negative.

Now, when you buy a call option, your risk is limited to the premium that you have paid as you don’t have to exercise the option if it’s making a loss. At the same time, your return from the option is unlimited, as there is no saying how high the price of the underlying may rise. When you sell a call option, the equation is reversed. Your return is limited by the amount you have collected as premium while your risk is unlimited (to the point where the price of the stock falls to zero).

Let’s apply this risk return equation to the spread that we have created by considering two scenarios – when the price of the underlying falls and when it goes up.

Scenario 1 – Price of the underlying moves up: When the price of the underlying moves up from $100 to $105, both the options remain out of the money and your net loss is your premium paid les premium collected, or $200. With a further rise in the price, your OTM call gets in the money. At a price of $107, the OTM call option makes you $200, which will offset the premium loss that you had taken to open the spread. The FOTM call remains out of the money and has no impact on your net position. This is your breakeven point.

If the price of the underlying rises further to reach $110, the FOTM call is at the money, and still does not influence your net position. But at this point your OTM call will make you $500. After adjusting for the initial premium loss, your spread will make a profit of $300.

If the underlying continues its rally and the price keeps going further up, then every dollar that you make on the OTM call will be offset by a dollar lost on the FOTM call, as the second option too will be in the money. In other words, your return for this spread is limited to $300, while the maximum amount that you can lose in this scenario is $200.

Scenario 2 – Price of the underlying goes down or remains the same: When the price of the underlying goes down or remains the same, against your expectations of course, at no point will you be in a profit making position. Both the call options will remain out of the money, and hence worthless. They will not impact your position and your net loss will remain at $200.

Thus, the overall maximum return that you can make from the spread is $300, when the price of the underlying is at $110, and the maximum risk of your position is $200. This can be an extremely useful situation for those who don’t want to risk a lot of their capital but want to make a bullish call on the underlying.

The benefit of the spread as a risk-limiting tool is evident when you compare it with an outright option. If you had just bought the OTM call in this example and not balanced it with the sale of an FOTM call, your maximum risk would be $400, as until the price of the underlying goes beyond $105, the option will remain out of the money and you will lose the whole of your premium. Of course, your return potential is also limitless, so an aggressive investor who is bullish on the underlying may still want to go with an outright option.

Similarly, if you were an aggressive investor bearish on the underlying, and had just gone out and sold the FOTM call in the previous example, your return would be capped at $200 (the premium collected) and your loss will be limitless. So in effect, a spread offers a solution that lies between these two aggressive strategies.

Vertical Bear Put Debit Spread

A vertical bear put debit spread can be understood in a similar way as a vertical bear call debit spread, with the key difference being that here you use put options to construct the spread and your view of the underlying is bearish. The spread will again be constructed using the same underlying and with the same expiry.

To construct a vertical bear put debit spread, you can buy an at-the-money (ATM) put and sell an FOTM put of the same underlying. The initial impact of the trade on your position will be a net debit, as the premium collected on an FOTM put will be lower than the premium that you’ll have to pay for an ATM put.

If the price of the underlying goes down, which is what you want, the ATM put will be in the money, and your position will become positive. If the price continues to fall beyond the strike price of your FOTM put, every dollar that you make on the ATM put will be offset by a dollar lost on the FOTM put. Your maximum profit will be when the price of the underlying reaches the FOTM put strike price.

On the other hand, when the price of the underlying goes up, both put options remain out of the money and your loss is limited to your initial account debit. The whole process is similar to how you earn or lose money in a vertical bear call debit spread, but completely reversed.

Vertical Bear Call Credit Spread

Another way to create a vertical spread is to reverse the transactions that you made in a vertical bull call debit spread. This time, instead of buying an OTM call, you sell it, and instead of selling an FOTM call, you buy it. This would create a bearish position on the underlying, where you are hoping for the price to remain roughly the same or go down.

By considering the previous example, you can see that such a spread will leave net credit in your account. You would pay a premium of $200 to buy the FOTM call with a $110 strike price, and would collect $400 when you write the OTM call with a $105 strike price. The moment you create this spread, you will be making a profit of $200. If nothing changes in the market, you will still make money, which is the reason why this is a good strategy when you have a neutral outlook.

This strategy will also help you make money in case of a bearish outcome. Think about what happens when the price of the underlying goes down to $95. Both legs of your spread remain out of the money and if things remain the same at the time of expiry, they will be worthless, as there would be no point in exercising them. Your profit will remain at $200, which is also the upper limit of your profit.

Now think about what happens if your prediction was wrong and the price of the underlying moves up.

• At $102 spot price, both of your calls with still be out of the money and your profit will be intact.
• At $107, your OTM call will be in the money and you will be losing $200 on it. This loss will completely wipe out the profit that you made on the difference of premiums and your net position will have no profit, no loss. This is the breakeven point of your spread.
• At $110, you are facing the worst possible outcome. You are losing $500 on the OTM call and you are making no money on the FOTM call. Even after accounting for the difference in premiums, you are still losing $300 on the spread. This is the maximum loss that you can make on this spread.
• Beyond $110, every dollar that you lose on your OTM call will be offset by a dollar earned on the FOTM call. Your loss will remain at $300, no matter how high the price of the underlying goes.

Thus, the overall maximum return that you can make from the spread is $200, when the price of the underlying is below $105, and the maximum risk of your position is $300. As you can see, this is an exact opposite of the risk-return situation in a vertical bull call debit spread.

It’s easy to understand why an investor would settle for a lower maximum return in this case, despite the higher risk – this spread puts you in a profitable situation immediately, and as long as the underlying does not make a swift move upwards, you would end up making some money on the spread. On the other hand, in a debit spread, the underlying must move upwards swiftly for you to make money.

Vertical Bull Put Credit Spread

As you would have guessed by now, you can also construct a credit spread by using put options instead of calls. You just need to sell an ATM put option as the first leg and at the same time, buy an FOTM put option as the second leg of the spread. You will have an immediate credit in your account and you would make money as long as the outcome is neutral or bullish.

In case, the price of the underlying starts falling, your position will make a loss, but the loss will be limited due to the opposite effect of the two puts after the FOTM strike price has been breached.

You can see that in case of debit spreads, time is your enemy. With every passing day when the price of the underlying doesn’t move significantly, the probability of a loss goes up. On the other hand, in case of credit spreads, time is your friend. As you get closer to expiry without seeing a major move in the price of the underlying, the probability of profit goes up.

Next Chapter: Calendar Option Spreads