An In-Depth Look At Vertical Option Spreads, Part I

In the next two lessons, I hope to examine vertical spreading in much greater detail. Together, we will investigate the composition, risk-and-reward profiles, and the breakeven points for the Bull Call Spread, the Bull Put Spread, the Bear Call Spread, and the Bear Put Spread. By the end of the next two lessons, and with a little amount of work, you will have begun to build a solid foundation as a sophisticated ‘Spreader’.

I. Some Prefatory Remarks

Before we begin our discussion of Vertical Spreads proper, I think it wise to make sure we are all on the same page concerning some basic terminology and concepts. In this brief Prefatory section, I want to: a) distinguish Credit from Debit spreads, b) note the criterion for distinguishing a spread’s “bullishness” or “bearishness,” and c) examine the risk/reward profiles of the underlying and a naked call, so as to compare it with that of these spreads.

a) Credit vs. Debit Spreads

A Credit Spread is, simply put, one in which the receipt of cash from the short option exceeds the amount of cash paid out for the long option, including transaction costs. Thus, recalling terminology from Accounting 101, when a trader puts on a credit spread, he receives money, or establishes a credit. As we will clarify below, good examples of a credit spread would be the Bull Put Spread and the Bear Call Spread.

Conversely, a Debit Spread is one in which the amount of cash paid out for the long option exceeds the amount received for the short option, including transaction costs. Thus the trader who puts on this position ends up with a debit, or an out-flow of cash. Bull Call Spreads and Bear Put Spreads are debit spreads, but flag that comment for the time being.

b) Beginners tend to equate Bull Spreads with Call Spreads and Bear Spreads with Put Spreads. After all, long calls are bullish and long puts are bearish, so it follows that all call spreads are bullish and all put spreads bearish, right? Wrong.

What determines whether a spread is bullish or bearish is not whether it is composed of puts or calls. Rather, if the trader/investor buys the option with the lower exercise price and sells the option with the higher exercise price the spread is bullish; and conversely, if he buys the higher exercise price and sells the lower one the spread is bearish. Period. That this rule is in fact valid, will become clear as we move along.

c) There is no better way to introduce the benefits of spreading than by directly comparing a spread’s risk/reward profile with the purchase of the underlying or a “naked” option. I don’t want to give you a lot of verbiage that may sound impressive; rather, I want you to look-and-see why Spreading can be so valuable.

Assume we are dealing with the purchase of 1 XYZ April 40 call @ $5 with the underlying trading at $42. The risk/reward profile would look like this:

1. Breakeven: Since I paid 5 bucks for it, I would break even on the April 40 call if ABC stock was trading at $45. Why? Because I have to recoup my $5 payment for premium! $40 + $5= $45

2. Profit: I would make money on the April 40 call for every gain above the Break-even point. Since theoretically, the stock price could go up infinitely, my potential profit is unlimited.

3. Loss: If the option closes below $45, I lose money. The great thing about options, as we all know, is that I don’t have to worry about how far below 45 the stock closes. It’s not a dollar for dollar loss like if I simply owned the stock. The most I can lose is the total premium I paid, here $5. Not a bad deal.

Well, you might say, 5 bucks ($500 per contract purchased) is better than the loss on a straight out purchase of the stock! I’ll just buy the call! But what if you bought 100 calls? Now we’re talking 50,000 bucks! 1,000 calls would be 500,000 bucks! And so on, and so on… Take the case of 100 calls, where you control the equivalent of 10,000 shares of stock. I don’t know about you but I don’t want to gamble on throwing away fifty grand unless I am REALLY sure of what’s going to transpire. Enter the Spread…

II. The Bull Call Spread

The Bull Call Spreader is Bullish in his attitude towards the underlying in question, but perhaps not so bullish as to merely buy the underlying or naked calls. He wants to gain from the foreseen increase in price of the underlying, but isn’t confident enough to “bet the farm” that the underlying will go up. A hedged position is best for him. So he chooses to put on a Bull Call Spread, enabling him to put on a bullish position with a bit of an insurance policy, if you will, for a lower cost than a naked call and a lot less risk than owning the stock. We shall see why this is so in a moment.

Remember we said that a bull call spread is simply a combination of two options, a long one with a lower strike price and a short one with a higher strike price, where both options are of the same type and expiration but have different strike prices.

Let’s look at an example:

BUY 1 ABC April 40 call @ $5
SELL 1 ABC April 50 call @ $3
Net cost of April ABC Bull Spread $2

OK, so what is the possible risk, reward and breakeven point of this Bull Call Spread and how would the risk and reward profile of an outright call compare? Get out those calculator’s, and lets get to work:

a) Loss: Let’s start with the easy part. The most the Bull Call Spreader can lose is $3, (or $300 per spread) ; Why? Because he paid $5 for one April 40 call, incurring a $5 debit; but sold one April 50 call for $3, generating $3 credit, and (worst case scenario) because options are the right but not the obligation to engage in a transaction, the guy can just let them both expire worthless if he so wishes. Doing the math: $5 - $3= $2. That’s a lot better than losing all $5 on the straight call purchase, right?

b) Profit: The big compromise in spreading is that the spreader loses the potential for unlimited gain that he had with the naked long call, or by owning the underlying outright. OK, figuring out the exact profit is best done by memorizing a simple little formula, so here it is. (I told you becoming a successful options trader required hard work and discipline…)

The profit is limited to the difference between the strike prices (higher-lower) minus the difference between the premiums (premium 1-premium2) , if and only if the underlying is above the second strike at expiration.

In the above example: (50-40) – (5-3)=(10)-(2) = $8

c) Breakeven: Another formula here but much easier: The Breakeven point is equal to the lower strike price plus the difference in premiums.
In our example: (40) + (5-3)=(40) + (2)= $42

So, our breakeven on this vertical is $42 per share on the stock.

As we mentioned in our introductory section, spreads can expose the investor to degrees of bullishness and bearishness: for example, if an investor is feeling more bullish, he can enter into a spread that offers a greater possibility of reward on the upside, with the trade off of costing more on the downside. Conversely, a seriously bearish investor can capitalize on a downside move. (Stay tuned for a future lesson!)

At expiration a Vertical Spread’s minimal value would be zero, if both options expire out-of-the money); and it’s maximum value being the amount between the exercise prices, if both options expire in-the-money.

III. The Bull Put Spread

Now let’s take a look at the Bull Put Spread. In the put market, the Bull Put Spread is the functional equivalent of the Bull Call Spread in the call market: the trader putting on the spread has a bullish view on the direction of the market, and he sells the higher strike put while purchasing the lower strike put. This scenario creates a net credit on the position as a whole because the premium of the short put is greater than the premium of the long put.

This is easy stuff. Let's look at the maximum profit we can make, the maximum loss, and breakeven point:

a) Profit: SELL 1 XYZ July 55 put @ 6
BUY 1 XYZ July 50 put @ 4
$2 credit

The sale of this XYZ 50/55 put spread gives me an influx of 2 bucks for every time I put it on. This credit is the maximum profit I can achieve. Now let’s apply some of what we learned above. If at expiration, the underlying has a price above the exercise price of the short put, then both options expire worthless. Why? Because these are both puts, and a put is in-the-money only if it has intrinsic value. (And a put has intrinsic value only if the underlying price is below the strike price!).

b) Loss: What about the potential Risk of this position? We have seen that the reward can only equal the credit earned. Memorize this, boys and girls:

The worst-case scenario for the Bull Put spreader would be if the underlying expires below the Higher strike price less the premium collected at expiration. The seller of this spread can lose the difference in the strike prices minus the initial Credit.

Max Loss: (55-50) – 2= $3

Below 50, the 55 put is always worth 5 points more than the 50 put, right? The 5 point maximum value of the spread minus the credit we received gives us the maximum loss.

c) Breakeven: Remember, this is a bull spread, albeit composed of puts.

Thus we have already seen how to calculate the break-even point. The breakeven point of a Bull Put Spread is always the strike price of the higher option minus the difference in premiums. Here 55 – ( 6-4) 55 - 2 = 53

So, our breakeven on this vertical is $53 per share on the stock.

Before we conclude this lesson, we should say a bit about the reasons, or motivations, an options trader might have for selecting one of the above spreads over the other one. So why would I select a Bull Call Spread over a Bull Put Spread, or vice versa? Well, I ask you, start thinking like a trader.

One reason would be that one is a credit spread ( I will take some money in), whereas the other is a debit spread ( I have to pay money out). Another reason might be that there is more risk of early exercise with puts.

These are just a few reasons: I want you to come up with some more on your own! Feel free to write me with what you come up with. Always remember that the successful trader is the one who learns to think for himself under pressure! That’s all for now.

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• How To Trade Trendless Stocks
• S.O.S. 'Simple Option Spreads'
• An In-Depth Look At Vertical Option Spreads, Part II
• Playing A Takeover
• Debit Spreads

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