Vertical spreads are created by same kind of options (call or put) on the same underlying security and with the same maturity date but different strike prices. For instance, Iron Condor strategy that’s been demonstrated in the previous post is a strategy that is comprised of 2 vertical spreads.
An investor would typically invest in vertical spread strategies when a limited directional movement is expected. If he or she has a strong expectation of the limited move in the underlying price vertical spreads can be a perfect strategy to employ while providing protection in case the investor is caught in the wrong direction at a cost of capping the potential profits. We will explain this phenomenon further with examples and demonstrations.
Let’s take a closer look at all the different type of spreads that are usually utilized in the investment world. There are commonly two bull spreads and two bear spreads. Bull spreads are bull call spreads and bull put spreads.
Bull Spreads
A bull call spread is created by purchasing a call option with a lower strike price and selling a call option with a higher strike price
Bull put spread: A bull put spread is created by purchasing a put option with a lower strike price and selling a put option with a higher strike price.
You might realize both bull spreads involve purchasing the option with lower strike price and selling the option with higher strike price. In terms of premium cost and gain this has different implications. Since call options get more expensive as the strike price goes lower (as call options give the right to purchase at the strike price purchasing right at a lower price creates higher intrinsic value), bull call spread will result in a negative cash flow (Low premium gained – High premium paid). Bull put spread, however, will result in a positive cash flow since put option with the lower strike price is going to cost cheaper than put option with the higher strike price.
Maximum Profit and Loss | ||
Vertical Spread: | Bull Call | Bull Put |
Maximum Profit: | the spread between the | Premium collected (credit) |
Maximum Loss: | Premium paid (debit) | the spread between the |
Both bull call spreads and bull put spread will be profitable if the underlying price increases. There will be a cap on the profit though limiting the profit at a certain value no matter how much the underlying price increases. That’s why it is rather suitable if the investor believes the rise potential is limited. Since the maximum possible loss is also limited bull spreads are not as risky as naked option investments or plain vanilla option investments. (Plain vanilla is a term used in finance to signify most basic, standard or simplest version of financial instruments such as options, bonds, swaps or futures.)
Bear Spreads
A bear call spread is created by purchasing a call option with a higher strike price and selling a call option with a lower strike price
Bear call spread can be a valuable investment strategy if the market insight is limited downside regarding the underlying price. In this situation bear call spread will allow capped profits based on the falling underlying prices while providing limited loss profile in case the insight is wrong and the underlying price starts rising.
A bear put spread is created by purchasing a put option with a higher strike price and selling a put option with a lower strike price.
You might realize both bear spreads involve purchasing the option with higher strike price and selling the option with lower strike price. In terms of premium cost and gain this has different implications similar to what we saw in bull spreads. Since call options get more expensive as the strike price goes lower (as call options give the right to purchase at the strike price purchasing right at a lower price creates higher intrinsic value), bear call spread will result in a positive cash flow (High premium gained – Low premium paid). Bear put spread, however, will result in a negative cash flow since put option with the lower strike price is going to cost cheaper than put option with the higher strike price.
Both bear call spreads and bear put spread will be profitable if the underlying price decreases. There will be a cap on the profit limiting the profit at a certain value no matter how much the underlying price decreases. That’s why it is rather suitable if the investor believes the fall potential is limited. Since the maximum possible loss is also limited bear spreads are not as risky as naked option investments or plain vanilla option investments. (Plain vanilla is a term used in finance to signify most basic, standard or simplest version of financial instruments such as options, bonds, swaps or futures.)
Maximum Profit and Loss | ||
Vertical Spread: | Bear Call | Bear Put |
Maximum Profit: | Premium collected (credit) | the spread between the |
Maximum Loss: | the spread between the | Premium paid (debit) |
Vertical spreads are one of the most convenient ways to bring in regular income from option investments. Since you are involved in both buying and selling and option pair the whole strategy is about obtaining a capped profit or recurring limited losses. It is never easy to be right 100% of the time when it comes to the markets. Even the most professional investors and traders stay on the wrong side every now and then. This is why the protection provided by vertical spreads can be very handy for a portfolio with a stable income.
Another point about the usefulness of vertical spreads is by adjusting the strike prices carefully you can design the exact spread you would like to achieve. If it’s a bull spread, you can profit from increasing underlying prices and if it’s a bear spread, you can profit from decreasing underlying prices. But if your insight is wrong your loss will have a maximum limit. Let’s look at some examples that will make you have a much better understanding of 4 different vertical spreads that are commonly utilized by most experienced finance professionals.
Example 1: Bull Call Spread
While Amazon is trading at $1696…
Bull Call Spread (@AMZN) | |
Long call | Short call |
Strike $1665, term: 3 months | Strike $1725, term: 3 months |
Price: $140.00 | Price: $97.60 |
Long call; Strike: $1665, maturity: 3 months ahead (option trading at $140)
Short call; Strike: $1725, maturity: 3 months ahead (option trading at $97.60)
Net premium result: $97.60 – $140 = -$42.40 (debit: net investment required)
Scenario 1: Amazon share price increases to $1750. Both call options would be in the money in this scenario, but the long call option would be deeper in the money as following:
$1750 – $1665 = $85 (long call option position)
$1750 – $1725 = $25 (short call option position)
Vertical Spread is now worth $85 – $25 = $60
After adjusting with the initial investment total net result is: $60 – $42.40 = $17.60 (Profit)
Scenario 2: Amazon share price decreases to $1550. Both call options would expire worthless and hence not be exercised in this scenario, meaning the whole amount of initial investment would be lost
Total result: -$42.40 (Loss)
Example 2: Bull PUT Spread
While Amazon is trading at $1696…
Bull Put Spread (@AMZN) | |
Long put | Short put |
Strike $1645, term: 3 months | Strike $1785, term: 3 months |
Price: $90.00 | Price: $149.25 |
Long put: Strike: $1645, maturity: 3 months ahead (option trading at $90)
Short put: Strike: $1785, maturity: 3 months ahead (option trading at $149.25)
Net premium result: $149.25 – $90 = $59.25 (credit: net premium collected)
Scenario 1: Amazon share price decreases to $1500. Both put options would be in the money in this scenario, but the short put option would be deeper in the money as following:
$1500 – $1785 = -$285 (short put option position)
$1645 – $1500 = $145 (long put option position)
Vertical Spread is now worth $145 – $285 = -$140
After adjusting with the initial premium gains total net result is: -$140 + $59.25 = -$-80.75 (Loss)
You can also see that this result is equal to strike price difference + premiums collected initially.
Scenario 2: Amazon share price increases to $1850. Both put options would expire worthless and hence not be exercised in this scenario, meaning the whole amount of initial collected premiums would be realized profit.
Total result: $59.25 (Profit)
Example 3: bear Call Spread
While Amazon is trading at $1696…
Bear Call Spread (@AMZN) | |
Long call | Short call |
Strike $1800, term: 3 months | Strike $1600, term: 3 months |
Price: $64.50 | Price: $167.00 |
Long call: Strike: $1800, maturity: 3 months ahead (trading at $64.50)
Short call: Strike: $1600, maturity: 3 months ahead (trading at $167.00)
Net premium result: $167 – $64.50 = $102.50 (credit: net premium collected)
Scenario 1: Amazon share price increases to $1810. Both call options would be in the money in this scenario, but the short call option would be deeper in the money as following:
$1810 – $1800 = $10 (long call option position)
$1810 – $1600 = $210 (short call option position)
Vertical Spread is now worth $10 – $210 = -$200
After adjusting with the initial investment total net result is: $102.50 – $200 = -$97.50 (Loss)
Please note how loss is equal to difference between strike prices plus the initial net premium gain.
Scenario 2: Amazon share price decreases to $1550. Both call options would expire worthless and hence not be exercised in this scenario, meaning the whole amount of initial investment would be lost.
Total result: -$42.40 (Loss)
Example 4: bear put Spread
While Amazon is trading at $1696…
Bear Put Spread (@AMZN) | |
Long put | Short put |
Strike $1780, term: 3 months | Strike $1640, term: 3 months |
Price: $135.30 | Price: $77.10 |
Long put: Strike: $1780, maturity: 3 months ahead (trading at $135.30)
Short put: Strike: $1640, maturity: 3 months ahead (trading at $77.10)
Net premium result: $77.10 – $135.30 = -$58.20 (debit: net investment required)
Scenario 1: Amazon share price decreases to $1550. Both put options would be in the money in this scenario, but the long put option would be deeper in the money as following:
$1780 – $1550 = $230 (long put option position)
$1780 – $1640 = $140 (short put option position)
Vertical Spread is now worth $230 – $140 = $90
After adjusting with the initial investment total net result is: $90 – $58.20 = $31.80 (Profit)
Scenario 2: Amazon share price increases to $1880. Both put options would expire worthless and hence not be exercised in this scenario, meaning the whole amount of initial investment would be lost.
Total result: -$58.20 (Loss)
