One of the most basic spreads to run with options is a vertical spread. A vertical spread is comprised of two options: a long option and a short option on the same underlying and expiration. We can configure your long option and short option into four different combinations: bull call spread, bear call spread, bull put spread and bear put spread.
We will go through each of these spreads and discuss how and when we use them. We will also focus on strike and expiration selection which can be the real trick with placing a spread.
Why Do We Use Vertical Spreads
Vertical spreads carry with them several advantages:
- Theta decay is neutralized
- Cost are lower
- Reduced exposure to vega
Before we get into the particulars of each spread we need to discuss when we would actually use a vertical spread versus a straight call or put. When choosing a straight long call or long put you are making a bullish or bearish bet, respectively. While you have delta on your side the downfall is you have theta working against you. As they say, time is fleeting. You know that if your underlying doesn't move quick enough your play will lose money even though it still heads in the right direction.
One of the benefits of a vertical spread is you are both long an option (negative theta) and short an option (positive theta). Now you won't completely cancel out theta since the more out-of-the-money you go the lower your theta number will be, but you will gain the benefit of lowering your theta giving your underlying more time to move.
Another big advantage, to most traders, is that vertical spreads will be cheaper to enter compared to a long call or long put. This occurs because you are offsetting the cost (debit) of a long option with the credit of a short option. Yes you will pay a bit more in commissions but this usually won't cancel out the benefit of a cheaper spread.
Now that we don't have to worry about time lets focus on volatility. Much like theta we are going to be both positive volatility (long option) and negative volatility (short option) so our exposure to changes in volatility will be smaller. This leads us to two main assumptions. One, we don't want to use verticals spreads if we are looking to take advantage of a rise or fall in volatility. Second, if volatility is on the extremes, too high or too low, we don't want to use vertical spreads. When volatility is too low it is almost always better to go with the long call or long put versus the spread. Being long the option will allow you to take advantage of the rise in volatility. Plus, a rise in volatility will negate the affect of time decay.
Bull Call Spread
Bull call spreads are bullish positions built with two call options. You will long the near option (higher delta) and short the further out-of-the-money option (smaller delta). Since your short option is further out-of-the-money the credit will be smaller than your debit. This causes the whole position to be established for a net debit.
The Option Prophet (sym: TOP) is trading at $45 and we want to enter a bull call spread. We see the 47 strike calls are trading at 3.00 and the 52 strike calls are at 0.75. We will buy the 47 strike and sell the 52 strike for a net debit of 2.25.
The downside of vertical spreads is that they have a max profit. We can figure out our max profit potential by taking the difference between the strikes and subtracting out our debit.
Using the numbers from the above example we have: 52 - 47 - 2.25 = 2.75 as our max profit.
We can achieve our max profit if TOP finishes at or above our short strike (52) at expiration. Our max loss will be achieved if TOP does not reach our long strike by expiration.
Since we are long this spread we will have a positive delta, negative theta, negative vega, negative gamma. Since we are both long and short most of our Greeks are neutralized. We want an increase in stock price, hence the positive delta. Time and volatility still hurt the position but the pain is a lot less now that we have a spread. Gamma is working against us because our spread and profit is capped.
Bear Call Spread
Bear call spreads are bearish positions built with two call options. This time we will short the near option (higher delta) and long the further out-of-the-money option (lower delta). Since we are short the higher delta our credit will be over the debit. The entire position will be established for a net credit.
TOP is trading at $60 and we want to enter a bear call spread. We see the 63 strike is trading at 4.00 and the 68 call strike is trading at 1.75. The total credit we would receive from this trade is $2.25. The credit we receive is our max profit for this trade.
To find our max loss we need to take the difference between the strikes minus our total credit. Using the numbers from above we have: 68 - 63 - 2.25 = 2.75.
The plus to trading for credits is that we don't need movement in the underlying. As long as TOP finishes below our short strike (63) at expiration we will collect the full credit. If TOP decides to rally and finishes above 68 we will take the max loss on the position.
This position, since we are bearish, has a negative delta. Theta can be both negative and positive depending on where the underlying is in relation to your strikes. If you are closer to the short strike your theta will be positive and you will make money as time passes. If your underlying begins to move more towards the long strike you theta will become negative and you will lose money as time passes.
This make sense since we make money when the underlying finishes below our short strike. The closer it is to the long strike the greater the chance we will reach max loss.
Bear Put Spread
A bear put spread is a bearish position built with two put options. You will long the higher delta put option and short the lower delta put option. Since the premium will be higher for the higher delta versus the lower delta this trade will be established for a net debit.
TOP is trading at $30 and we think it will decrease. We are looking at going long on the 28 strike put for 3.00 and shorting the 25 strike put for 1.00. The complete trade would generate a net debit of 2.00.
Like a bull call spread, which we also trade for a debit, our max profit is the difference between the strikes minus the debit. Using our numbers from the example above we have a max profit of: 28 - 25 - 2.00 = 1.00.
If the underlying drops below the short strike we will receive our max profit. If, instead, the underlying finishes above the long strike we will take our max loss which is our debit. We are bearish in this position which means we carry a negative delta along with a negative theta, gamma, and vega.
Bull Put Spread
Bull put spreads are bullish positions built with two put options. We short the higher delta option and long the further out-of-the-money, lower delta option. Since we are short the higher delta versus long the lower delta our position will be established for a net credit.
TOP is trading at $80 and we think the price will rise. We decide to place a bull put spread by shorting the 79 strike at 5.00 and going long the 75 strike at 2.00. Our credit and max profit for this position is 3.00.
We can figure out our max loss on the position by taking the difference between the strikes minus the credit that we received. Using the numbers from above our max loss is: 79 - 75 - 3.00 = 1.00.
Since we are bullish our delta will be positive while the rest of our Greeks are negative.
How We Choose Our Strikes For The Spread
There are several ways we can choose our strikes: target price, skew or by return. A lot of traders will choose their strikes based on target price. If they think the underlying is going to head to a specific price they will set their short strike at that price.
TOP is trading at $60 and we think it is going to $70. We can trade a bull call spread buy going long the 65 strike call and short the 70 strike call. Now if TOP moves up to $70 like we expect we stand to make our full profit on the bull call spread.
Another more advanced way to pick our strikes is by looking at an option's skew. Skew is created through an option strike's volatility. Each strike in an option chain carries its own implied volatility. A lot of times this implied volatility can fall out of whack making one strike have a higher or lower implied volatility compared with the strikes around it. When we notice that an option strike is too cheap because its implied volatility is too low that is the strike we want to go long on. When we notice that an option strike is too expensive because its implied volatility is too high that is the strike we want to go long on.
Looking at volatility skew is a great way to find your strikes for your vertical spreads. However, it can be quite challenging if you do not have a good program for looking at skew such as LiveVol.
The way we typically use is by looking at the various strikes and seeing which ones offer a better risk and reward. Let's look at an example:
TOP is trading at $50 and we are looking to enter a bull call spread. We can either go long the 51 strike calls and short the 52 strike calls for 0.25 or we can go long the 51 strike calls and short the 53 strike calls for 0.45. Instead of just going after the lowest debit we should compare apples to apples.
Strikes 51/52 for 0.25 credit:
We could enter 200 spreads for a total cost of $5000 which would give us a max profit of $15,000.
Strikes 51/53 for 0.45 credit:
We could enter 100 spreads for a total cost of $4500 which would give us a max profit of $15,500.
As you can see it would be better to trade the 51/53 strikes versus the 51/52. It offers a better reward for a cheaper price.
You should use vertical spreads when you don't want to take a position in volatility but a position in direction. Since you are both long and short most of our Greeks will be minimized. This is especially usefully when dealing with time (theta). Vertical spreads will allow you to remain in the trade longer without feeling the harmful effects of theta decay.
Choosing between a credit spread or debit spread depends on your overall expectation. If you are bullish or bearish you should enter the bull call spread or bear put spread, respectively. If you are neutral or only slightly bullish or bearish than you should enter the bull put spread or bear call spread, respectively. Credit spreads tend to make money if the underlying doesn't move or just moves slightly in your favor. Hence, you want to go with them when you expectations of movement are low.
When choosing strikes it is a good idea to compare risk and reward of the various strikes. Make sure you compare apples to apples.
How do you like to use vertical spreads? Tell us in the commnets...