Vertical Debit Spread Explained

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Contents

Vertical Credit Spread

The vertical credit spread is a vertical spread whereby a net credit is received when entering the position. A bullish vertical credit spread can be constructed using put options and is known as the bull put spread. A bearish vertical credit spread can be created using call options and is known as the bear call spread.

Vertical Debit Spread

Vertical spreads can also be entered on a debit. See vertical debit spread.

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Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

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Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

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Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Bull Call Spread

The bull call spread option trading strategy is employed when the options trader thinks that the price of the underlying asset will go up moderately in the near term.

Bull call spreads can be implemented by buying an at-the-money call option while simultaneously writing a higher striking out-of-the-money call option of the same underlying security and the same expiration month.

Bull Call Spread Construction
Buy 1 ITM Call
Sell 1 OTM Call

By shorting the out-of-the-money call, the options trader reduces the cost of establishing the bullish position but forgoes the chance of making a large profit in the event that the underlying asset price skyrockets. The bull call spread option strategy is also known as the bull call debit spread as a debit is taken upon entering the trade.

Limited Upside profits

Maximum gain is reached for the bull call spread options strategy when the stock price move above the higher strike price of the two calls and it is equal to the difference between the strike price of the two call options minus the initial debit taken to enter the position.

The formula for calculating maximum profit is given below:

  • Max Profit = Strike Price of Short Call – Strike Price of Long Call – Net Premium Paid – Commissions Paid
  • Max Profit Achieved When Price of Underlying >= Strike Price of Short Call

Limited Downside risk

The bull call spread strategy will result in a loss if the stock price declines at expiration. Maximum loss cannot be more than the initial debit taken to enter the spread position.

The formula for calculating maximum loss is given below:

  • Max Loss = Net Premium Paid + Commissions Paid
  • Max Loss Occurs When Price of Underlying

Breakeven Point(s)

The underlier price at which break-even is achieved for the bull call spread position can be calculated using the following formula.

  • Breakeven Point = Strike Price of Long Call + Net Premium Paid

Bull Call Spread Example

An options trader believes that XYZ stock trading at $42 is going to rally soon and enters a bull call spread by buying a JUL 40 call for $300 and writing a JUL 45 call for $100. The net investment required to put on the spread is a debit of $200.

The stock price of XYZ begins to rise and closes at $46 on expiration date. Both options expire in-the-money with the JUL 40 call having an intrinsic value of $600 and the JUL 45 call having an intrinsic value of $100. This means that the spread is now worth $500 at expiration. Since the trader had a debit of $200 when he bought the spread, his net profit is $300.

If the price of XYZ had declined to $38 instead, both options expire worthless. The trader will lose his entire investment of $200, which is also his maximum possible loss.

Note: While we have covered the use of this strategy with reference to stock options, the bull call spread is equally applicable using ETF options, index options as well as options on futures.

Commissions

For ease of understanding, the calculations depicted in the above examples did not take into account commission charges as they are relatively small amounts (typically around $10 to $20) and varies across option brokerages.

However, for active traders, commissions can eat up a sizable portion of their profits in the long run. If you trade options actively, it is wise to look for a low commissions broker. Traders who trade large number of contracts in each trade should check out OptionsHouse.com as they offer a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the bull call spread in that they are also bullish strategies that have limited profit potential and limited risk.

Vertical Spreads

The vertical spread is an option spread strategy whereby the option trader purchases a certain number of options and simultaneously sell an equal number of options of the same class, same underlying security, same expiration date, but at a different strike price.

Vertical spreads limit the risk involved in the options trade but at the same time they reduce the profit potential. They can be created with either all calls or all puts, and can be bullish or bearish.

Bull Vertical Spreads

Bull vertical spreads are employed when the option trader is bullish on the underlying security and hence, they are designed to profit from a rise in the price of the underlying asset. They can be constructed using calls or puts and are known as bull call spread and bull put spread respectively.

While they have similar risk/reward profiles, the bull call spread is entered on a debit while the bull put spread can be established on a credit. Hence, the bull call spread is also called a vertical debit spread while the bull put spread is sometimes referred to as a vertical credit spread.

Bear Vertical Spreads

Vertical spread option strategies are also available for the option trader who is bearish on the underlying security. Bear vertical spreads are designed to profit from a drop in the price of the underlying asset. They can be constructed using calls or puts and are known as bear call spread and bear put spread respectively.

While they have similar risk/reward profiles, the bear call spread is entered on a credit while the bear put spread can be established on a debit. Hence, the bear call spread is also called a vertical credit spread while the bear put spread is sometimes referred to as a vertical debit spread.

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Continue Reading.

Buying Straddles into Earnings

Buying straddles is a great way to play earnings. Many a times, stock price gap up or down following the quarterly earnings report but often, the direction of the movement can be unpredictable. For instance, a sell off can occur even though the earnings report is good if investors had expected great results. [Read on. ]

Writing Puts to Purchase Stocks

If you are very bullish on a particular stock for the long term and is looking to purchase the stock but feels that it is slightly overvalued at the moment, then you may want to consider writing put options on the stock as a means to acquire it at a discount. [Read on. ]

What are Binary Options and How to Trade Them?

Also known as digital options, binary options belong to a special class of exotic options in which the option trader speculate purely on the direction of the underlying within a relatively short period of time. [Read on. ]

Investing in Growth Stocks using LEAPS® options

If you are investing the Peter Lynch style, trying to predict the next multi-bagger, then you would want to find out more about LEAPS® and why I consider them to be a great option for investing in the next Microsoft®. [Read on. ]

Effect of Dividends on Option Pricing

Cash dividends issued by stocks have big impact on their option prices. This is because the underlying stock price is expected to drop by the dividend amount on the ex-dividend date. [Read on. ]

Bull Call Spread: An Alternative to the Covered Call

As an alternative to writing covered calls, one can enter a bull call spread for a similar profit potential but with significantly less capital requirement. In place of holding the underlying stock in the covered call strategy, the alternative. [Read on. ]

Dividend Capture using Covered Calls

Some stocks pay generous dividends every quarter. You qualify for the dividend if you are holding on the shares before the ex-dividend date. [Read on. ]

Leverage using Calls, Not Margin Calls

To achieve higher returns in the stock market, besides doing more homework on the companies you wish to buy, it is often necessary to take on higher risk. A most common way to do that is to buy stocks on margin. [Read on. ]

Day Trading using Options

Day trading options can be a successful, profitable strategy but there are a couple of things you need to know before you use start using options for day trading. [Read on. ]

What is the Put Call Ratio and How to Use It

Learn about the put call ratio, the way it is derived and how it can be used as a contrarian indicator. [Read on. ]

Understanding Put-Call Parity

Put-call parity is an important principle in options pricing first identified by Hans Stoll in his paper, The Relation Between Put and Call Prices, in 1969. It states that the premium of a call option implies a certain fair price for the corresponding put option having the same strike price and expiration date, and vice versa. [Read on. ]

Understanding the Greeks

In options trading, you may notice the use of certain greek alphabets like delta or gamma when describing risks associated with various positions. They are known as “the greeks”. [Read on. ]

Valuing Common Stock using Discounted Cash Flow Analysis

Since the value of stock options depends on the price of the underlying stock, it is useful to calculate the fair value of the stock by using a technique known as discounted cash flow. [Read on. ]

Which Vertical Option Spread Should You Use?

Understanding the features of the four basic types of vertical spreads—bull call, bear call, bull put, and bear put—is a great way to further your learning about relatively advanced option strategies. Yet, to deploy these strategies effectively, you also need to develop an understanding of which option spread to use in a given trading environment or specific stock situation. First, let’s recap the main features of the four basic vertical spreads.

Key Takeaways

  • Options spreads are common strategies used to minimize risk or bet on various market outcomes using two or more options.
  • In a vertical spread, an individual simultaneously purchases one option and sells another at a higher strike price using both calls or both puts.
  • A bull vertical spread profits when the underlying price rises; a bear vertical spread when it falls.

Basic Features of Vertical Spreads

Each vertical spread involves buying and writing puts or calls at different strike prices. Each spread has two legs, where one leg is buying an option, and the other leg is writing an option.

This can result in the option position (containing two legs) giving the trader a credit or debit. A debit spread is when putting on the trade costs money. For example, one option costs $300 but the trader receive $100 from the other position. The net premium cost is a $200 debit.

If the situation were reversed, and the trader receives $300 for putting on an option trade, and the other option costs $100, the two option contracts combine for a net premium credit of $200.

Types of Vertical Spreads

Here is how each spread is executed:

  • A bull call spread is purchasing a call option, and simultaneously selling another call option (on the same underlying asset) with the same expiration date but a higher strike price. Since this is a debit spread, the maximum loss is restricted to the net premium paid for the position, while the maximum profit is equal to the difference in the strike prices of the calls less the net premium paid to put on the position.
  • A bear call spreadis selling a call option, and simultaneously purchasing another call option with the same expiration date but at a higher strike price. Since this is a credit spread, the maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the calls less the net premium received.
  • A bull put spread is writing a put option, and simultaneously purchasing another put option with the same expiration date but a lower strike price. Since this is a credit spread, the maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the puts less the net premium received.
  • A bear put spreadis purchasing a put option, and simultaneously selling another put option with the same expiration date but a lower strike price. Since this is a debit spread, the maximum loss is restricted to the net premium paid for the position, while the maximum profit is equal to the difference in the strike prices of the puts less the net premium paid to put on the position.

The table below summarizes the basic features of these four spreads. Commissions are excluded for simplicity.

Spread

Strategy

Strike Prices

Debit / Credit

Max. Gain

Max. Loss

Break-Even

Bull Call

Strike price of C2 > C1

(C2 – C1) – Premium paid

Bear Call

Strike price of C2 > C1

(C2 – C1) – Premium received

Bull Put

Strike price of P1> P2

(P1 – P2) – Premium received

Bear Put

Strike price of P1> P2

(P1 – P2) – Premium paid

Credit and Debit Spreads

Vertical spreads are used for two main reasons:

  1. For debit spreads, to reduce the premium amount payable.
  2. For credit spreads, to lower the option position’s risk.

Let’s evaluate the first point. Option premiums can be quite expensive when overall market volatility is elevated, or when a specific stock’s implied volatility is high. While a vertical spread caps the maximum gain that can be made from an option position, when compared to the profit potential of a stand-alone call or put, it also substantially reduces the position’s cost. Such spreads can therefore be easily used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg.

As far as credit spreads are concerned, they can greatly reduce the risk of writing options, since option writers take on significant risk to pocket a relatively small amount of option premium. One disastrous trade can wipe out positive results from many successful option trades. In fact, option writers are occasionally disparagingly referred to as individuals who stoop to collect pennies on the railway track. They happily do so until a train comes along and runs them over!

Writing naked or uncovered calls is among the riskiest option strategies, since the potential loss if the trade goes awry is theoretically unlimited. Writing puts is comparatively less risky, but an aggressive trader who has written puts on numerous stocks would be stuck with a large number of pricey stocks in a sudden market crash. Credit spreads mitigate this risk, although the cost of this risk mitigation is a lower amount of option premium.

Which Vertical Spread To Use

Consider using a bull call spread when calls are expensive due to elevated volatility and you expect moderate upside rather than huge gains. This scenario is typically seen in the latter stages of a bull market, when stocks are nearing a peak and gains are harder to achieve. A bull call spread can also be effective for a stock that has great long-term potential, but has elevated volatility due to a recent plunge.

Consider using a bear call spread when volatility is high and modest downside is expected. This scenario is typically seen in the final stages of a bear market or correction when stocks are nearing a trough, but volatility is still elevated because pessimism reigns supreme.

Consider using a bull put spread to earn premium income in sideways to marginally higher markets, or to buy stocks at reduced prices when markets are choppy. Buying stocks at reduced prices is possible because the written put may be exercised to buy the stock at the strike price, but because a credit was received this reduces the cost of buying the shares (compared to if the shares were bought at the strike price directly). This strategy is especially appropriate to accumulate high-quality stocks at cheap prices when there is a sudden bout of volatility but the underlying trend is still upward. A bull put spread is akin to “buying the dips,” with the added bonus of receiving premium income in the bargain.

Consider using a bear put spread when moderate to significant downside is expected in a stock or index, and volatility is rising. Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid, like to hedge long positions after a strong bull market.

Factors to Consider

The following factors may assist in coming up with an appropriate options/spread strategy for the current conditions and your outlook.

  • Bullish or bearish: Are you positive or negative on the markets? If you are very bullish, you might be better off considering stand-alone calls (not a spread). But if you are expecting modest upside, consider a bull call spread or a bull put spread. Likewise, if you are modestly bearish or want to reduce the cost of hedging your long positions, the bear call spread or bear put spread may be the answer.
  • Volatility view: Do you expect volatility to rise or fall? Rising volatility may favor the option buyer, which favors debit spread strategies. Declining volatility improves the odds for the option writer, which favors credit spread strategies.
  • Risk versus reward: Is your preference is for limited risk with potentially greater reward, this is more an option buyer’s mentality. If you seek limited reward for possibly greater risk, this is more in line with the option writer mentality.

Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, the best strategy would be a bear put spread. Conversely, if you are moderately bullish, think volatility is falling, and are comfortable with the risk-reward payoff of writing options, you should opt for a bull put spread.

Which Strike Prices to Choose

The table above outlined whether the bought option is above or below the strike price of the written option. Which strike prices are used is dependent on the trader’s outlook.

For example, on a bull call spread, if the price of a stock is likely to stay around $50 until the options expire, you may buy a call with a strike near $50 or and a sell a call at $55. If the stock is unlikely to move much, selling a call at the $60 strike makes less sense because the premium received will be lower. Buying a call with a $52 or $53 strike would be cheaper than buying the $50 call, but there is less chance the price will move above $52 or $53 compared to $50.

There is always a trade-off. Before taking a spread trade consider what is being given up or gained by choosing different strike prices. Consider the probabilities that the maximum gain will be attained or that the maximum loss will be taken. While it is possible to create trades with high theoretical gains, if the probability of that gain being attained is minuscule, and likelihood of losing is high, then a more balanced approach should be considered.

The Bottom Line

Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading. Look at the current market conditions and consider your own analysis. Determine which of the vertical spreads best suits the situation, if any, then consider which strike prices to use before pulling the trigger on a trade.

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