# Vertical Spread Strategy Explained

Published on January 21, 2016

Published on January 21, 2016

**Vertical Spreads Strategies** are one of the most versatile form of option trading strategies. Some of you by now have become really good at Options Trading using Vertical Spreads for Income. But if you’re still struggling to nail Vertical Spread strategy, or if you’re just getting started in options trading world, this comprehensive article is most definitely for you.

Let’s kick off the New Year with an absolute game changer in your Options Trading. I’ve put a lot into this article for you, so make sure to read completely and ask questions to get everything you need to start the new year off successfully!

In this Vertical Spread focused article, you are going to learn:

- What is a
**Vertical Spread**? - Two ways you can
**structure a Vertical Bull Spread**? - 3 Different scenarios (Up, down and sideways) and
**how to calculate your risk/reward**. - Is Vertical
**Debit Spread**better or Vertical**Credit Spread**?

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

In Vertical Spread, when one option is making money, the other option is losing money and thus Vertical spreads limit the risk involved but at the same time they reduce the profit potential.

Vertical Spreads can be either **Debit Spread** or **Credit Spread**, and can be created with either all calls or all puts. Vertical Spreads can be bullish or bearish.

Bull vertical spread is an options trading strategy designed to profit from a rise in prices of the underlying asset we’re trading. It can be constructed in two ways:

- By using
**Put options**– “**Bull Put Spread**”, a Vertical**Credit Spread** - By using
**Call options**– “**Bull Call Spread**”, a Vertical**Debit Spread**

When structured for similar strike prices, similar expiration, both Bull Put Spread and Bear Call Spread have similar risk/reward profile. Attached **option table** below, that shows Apple Inc. (AAPL) Vertical Spreads real-time prices, confirms the same.

*How to read above Option Table:*

*It is $5 wide vertical spread (the difference between two strikes).**Look at “Mark” column. That is the “mid price” between bid and ask.**Call Options are on the left and Put Options are on the right.**If 100/105 Bull Call Vertical Spread Costs $2.16 to open, it’s maxim profit is $5-$2.16 = $2.84, almost the same as the credit by selling 105/100 Bull Put Spread at $2.87!*

One may choose either of the two of vertical spreads to trade his directional view. However, it is much better to structure a trade based on **Bid/ask slippage** and **Ease of fill**. Based on my experience, it is a good idea to structure a Vertical Spread using “out of the money” options for better fills. Using an example let’s review **Bullish Vertical Spread** first, along with possible outcomes (profit and loss). We will use a hypothetical example on a stock which is currently trading at $48 per share. For our example, let’s assume:

- Based on some technical or fundamental analysis, we are bullish on this stock and we expect the price to rise in the next 15 days
- Let’s suppose today is January 15th and we decided to go through with our bullish strategy based on our bullish signal.
- Expiration date of both our options is Jan 31st.
- Stock is currently trading at $48.00 per share.

Here is the price chart marked with entries for selecting spread using **Call Options**:

- First, we will buy
**Call options**with a strike price at $50.00, which is trading for $0.50 (for example) per share. Since options come in lots of 100 shares, we would spend $50 for this particular Call option. - Simultaneously, we will sell equal amount of
**Call options**with a higher strike price at $52.50. By selling this call for $0.20 per share (for example), we would receive $20 (100 shares X $0.20). - By setting up two options in this manner, we have constructed (or purchased) a
**Bull Call Spread**and it cost us $30. We paid $50 for the lower strike price Call Option (price at $50.00), while we received $20 by selling the higher strike price Call Option ($52.50). - Since it was a debit i.e. cash outflow to open this spread, it is called a
**Debit Spread**. In this case our Initial Debit is $0.30 per spread (or $0.30 X 100 = $30). Here is the same chart marked with profit/loss areas according to potential price movement by expiration date:

The price at $50.30 represents our breakeven point, and any price move above that value would result in profit.

- If the price stays or closes below our first strike point at $50.00, our loss would always be the same since it is determined (and capped) solely by our initial investment of the spread we purchased. Buying our first call at $50.00 strike price for $50 while selling our second call at 52.50 strike price for $20, our overall cost will be $30 ($50 – $20). We say our Debit Spread cost us $30.
**Debit amount in bull call spread is the maximum loss amount**. - If the price stays above $50.00 strike price, but below $50.30 value, our first long call option is starting to make some money (go in the money) and it will offset our loss caused by our initial investment, finally
**breaking even at $50.30**. - Price moving above $50.30 will increase our profit up to a point
**when it reaches $52.50**, where our short call is placed. That short call option is**“capping” our profit**, and any price movement above $52.50 will not result in any additional gains. It is the point where our short call option starts to work against us. - As the upper short call is losing money, our lower long call is making money – options are “hedged” against each other.
**Maximum profit is locked in when price is at or above short call $52.50 strike point – by expiration**.

Here is the visual representation of the risk/reward profile at expiration to explain what we just described above: Notice the X-Axis i.e. the stock price axis to see how price movement affects our profit/loss. As our purchased call option ($50.00 strike price) is getting “in the money”, our loss is being reduced. Once the price moves above the $50.30 value, we start profiting. That profit increases up to a price of $52.50, where our short option is placed. Notice how a further increase in price (for example it can move to $60 per share) doesn’t affect our maximum profit which is capped at $220. Vice versa, notice what would a potential decrease in stock price to $0 mean for our **vertical spread** – you’re correct – it doesn’t affect our loss amount.

In this case, we will make maximum gains. The profit will be calculated based on intrinsic values of each option at expiration.

- Intrinsic Value of sold Call Option (Stock Price- Strike price), Is = $57.00 – $52.50 = $4.50
- Intrinsic Value of purchased Call Option (Stock Price- Strike price), Ip = $57.00 -$50.00 = $7.00
- Profit/Loss = Ip –Is – Initial Debit = $7.00 – $4.50 – $0.30 = $2.20

Since each option controls 100 shares, our gains will be $2.20*100 = $220. That’s +733% gains ($220 / $30 = 733%)

In this case, we will make maximum loss. The loss, just like profit, will be calculated based on intrinsic values of each option at expiration.

- Intrinsic Value of sold Call Option (Stock Price- Strike price) = $49.00 – $52.50 = $0 (since it can’t have negative value)
- Intrinsic Value of purchased Call Option (Stock Price- Strike price) = $49.00 – $50.00 = $0 (since it can’t have negative value)
- Profit/Loss = Ip – Is – Initial Debit = $0 – $0 – $0.30 = –$0.30

Since each option controls 100 shares, our loss will be $0.30*100 = $30. Remember, this value actually represents our initial investment and thus 100% loss.

In this case, profit or loss will again be calculated based on intrinsic values of each option at expiration.

- Intrinsic Value of sold Call Option (Stock Price- Strike price), Is = $51.00 – $52.50 = $0 (since it can’t have negative value
- Intrinsic Value of purchased Call Option (Stock Price- Strike price), Ip = $51.00 -$50.00 = $1.00
- Profit/Loss = Ip – Is – Initial Debit = $1.00 – $0 – $0.30 = $0.70

Since each option controls 100 shares, our gains will be $0.70*100 = $70. That’s +233% gains ($70 / $30 = 233%)

First, we will **sell** **Put option** with a higher strike price at $52.50, and simultaneously, we will **buy** equal amount of **Put option** with a lower strike price at $50.00. Let’s assume that these two transactions, when combined, gave us $2.20 credit – since options come in lots of 100, our **credit** received for this **bull put spread** is $220. We are not allowed to consider this amount as our profit (yet) since it is only **initial credit** we received for constructing our spread in this manner. Assuming underlying price is in our favor, our profit will accumulate gradually and only materialize on expiration.

It is because we are comparing the risk/reward profile with respect to Bull Call Spread and we are using the same strikes. By setting up two options in this manner, **we have constructed (or sold) a Bull Put Spread** and we collected $220 credit. Since it gave us credit to open this spread, it is called a **Credit Spread**. In this case our Initial Credit (Ic) is $2.20 (or $2.20 * 100 = $220) Here is the same chart marked with profit/loss areas according to potential price movement by expiration date: Next, let us show what happens with our profit/loss when a stock price moves in different directions as we are nearing our expiration date.

- As soon as price reaches $50.00, our
**long put option**starts to**lose**money, but simultaneously, our**short put option**(at strike price of $52.50) is**producing profit**for us – as stock price moves higher. - Price at $50.30 represents our break even point, after which our profit from this setup starts increasing. It will increase up to a point when price reaches $52.50 – after this point, since both our positions are
**hedged**against each other, the maximum profit will not change. It is capped at $220, the initial credit.

Here is the visual representation of the risk/reward profile at expiration to explain what we just described above:

In this case, we’ll make maximum gains. The profit will be calculated based on intrinsic values of each option at expiration.

- Intrinsic Value of sold Put Option (Strike Price- Stock price), Is = $52.50 – $57.00 = $0 (since it can’t have negative value)
- Intrinsic Value of purchased Put Option (Strike Price- Stock price), Ip = $50.00 – $57.00 = $0 (since it can’t have negative value)
- Profit/ Loss = Initial Credit +Ip – Is = $2.20 + $0 – $0 = $2.20

Since each option controls 100 shares, our gains will be $2.20*100 = $220. That’s +733% gains ($220/$30 = 733%). We get to keep all the credit we collected to open this trade.

In this case, we’ll make maximum loss. The loss, just like profit, will be calculated based on intrinsic values of each option at expiration.

- Intrinsic Value of sold Put Option (Strike Price- Stock price) = $52.5 – $49.00 = $3.50
- Intrinsic Value of purchased Put Option (Strike Price- Stock price) = $50.00 – $49.00 = $1.00
- Profit/ Loss = Initial Credit +Ip – Is = $2.20 + $1.00 – $3.50 = –$0.30

Since each option controls 100 shares, our loss will be $0.30*100 = $30.

In this case, profits or loss will again be calculated based on intrinsic values of each option at expiration.

- Intrinsic Value of sold Put Option (Strike Price- Stock price), Is = $52.50 – $51.00 = $1.50
- Intrinsic Value of purchased Put Option (Strike Price- Stock price), Ip = $50.00 – $51.00 = $0 (since it can’t have negative value)
- Profit/ Loss = Initial Credit + Ip – Is = $2.20 + $0.0- $1.50 = $0.70

Since each option controls 100 shares, our gains will be $0.70*100 = $70. That’s +233% gains ($70/$30= 233%)

As you may notice, in both cases, the profit/loss (risk/reward) was same whether you chose Bull Put Spread or Bull Call Spread using the same strikes. However, as mentioned earlier, it is much better to **structure a trade** based on **bid/ask slippage** and **ease of fill**, and thus it will be much better to use **Bull Call Vertical Spread vs Bull Put Spread**. Out of the Money Calls will be much easier to be filled vs Deep In the Money Puts and bid/ask slippage will also be relatively smaller.

This post covers only **BULLISH VERTICAL SPREADS**. In the following post, I will cover **BEARISH VERTICAL SPREAD** and provide you more examples so you could follow through.

Finally, I have to remind you to be patient with yourself. This isn’t all going to fall into place tomorrow. My goal is to give you a roadmap and a bunch of examples, so you see where you want to go with your options trading and have the skills to get there day by day.

How do you like it? What additional thoughts or questions do you have? I will answer every question, no strings attached. Make sure to leave your comments or questions so you can make the most of your learning.

Profitable Trading, OP

Manoj, thanks for this excellent write up . I really like how the article is written in a simple, precise and easy to understand manner. It’s useful for beginners and easy enough for anyone new to options to understand and grasp a complex topic such as Options. And for the experienced options traders, there’s enough ‘meat’ to revisit and strengthen the foundation. Truly a lot of thought process has gone into organizing this, which is a great testament on your commitment to our success! Thank you and looking forward to many more great write ups from you!

Mr Manoj. Thanks again for a great info and I find it very helpful and come in handy. Yet I still got few questions and hope you can reply me.

1) How u adjust the strike price diff by $5 under option chain?

2) what is the duration? 1 month?

Thanks again Mr Manoj for this nice post. Below is my question.

1) how do you trade 100/105 under vertical option chain. I only get diff of $1.

2) what is the duration for this trade? 7 days?

Lastly) do we leave the option to expire? After expire we still get money?

@Alvin, Thank you.

@Jason, @Lim Yam Chee, Thank you for kind words.

Answers to your questions-

1) How u adjust the strike price diff by $5 under option chain?The Option strike prices are provided via the brokers and usually you can’t change the option strikes. Different stocks have different strikes. For instance- Alphabet (GOOG) has option strikes that are $2.5, $5 and even $10. While Apple (AAPL) has options strikes in the increments of $0.50, $1 and so on. The options strikes may also vary depending upon expiration. So the best approach is look at underlying’s options chain in your trading platform and use that to structure your trades.

2) what is the duration? 1 month?Duration is selected based upon your “time horizon” you expect for your market/underlying outlook to materialise.

3) do we leave the option to expire? After expire we still get money?If you sold options (via credit spreads) and it expires worthless, you get to keep your credit (i.e. profit). If however, your options are in the money, you might lose. Net net, you can open/close anytime. However, as expiration approaches, it is better to review risk/reward.

Hope this helps,

Profitable Trading

Thanks for the explanation. Appreciate and it do helps.

Even i subscribe the above article, but i not received mail, please help me to get the pdf copy of the same

@Brijesh, Allow 24hrs for the e-mail to be delivered right into mailbox containing link for the pdf copy. If you don’t get it, please notify (via e-mail) and I shall personally send you a link.

Dear Mr Manoj,

1) This is very useful article for the idea of vertical spread, but to make our trade to be much successful, do we consider the GREEKs as the criteria to be in this kind of strategy?

2) If I were to be in this trade for 3 ~ 5 days, is the selection of expiration to be at least 14 days?

3) As mentioned if we left the option till expire, and the option price is in the money, it is definite a loss.

However, why is that so, I supposed we purchase call at $50 and sell call at $52.50, and the stock price (say $48) goes against us, won’t we be able to gain the profit on the difference that we set earlier on?

For your info and necessary action, please.

I look forward in hearing from yoU soon.

Thanks and regards,

Lee

7 August 2016

Hi Manoj,

Many thanks for the sharing.

I have a question: If you sell a put at the OTM strike price (e.g. $52.50), won’t the buyer of the put want to exercise it since the strike price is higher than the underlying? The buyer can profit if his cost (premium plus the underlying at $50) is less than $52.50?

@Lee – Here are answers to your questions:

1) To make our trade to be much successful, do we consider the GREEKs as the criteria to be in this kind of strategy?It depends on your trading strategies and system. Greeks are part of the options trading.

2) If I were to be in this trade for 3 ~ 5 days, is the selection of expiration to be at least 14 days?It depends on your time frame and selection of strategy. The close to expiry you are, the more you might paying/collecting for time decay. Also the gamma impact will be larger too.

3) I supposed we purchase call at $50 and sell call at $52.50, and the stock price (say $48) goes against us, won’t we be able to gain the profit on the difference that we set earlier on?If you purchased $50 call, and sold 52.50 call, you paid some money thus it is a debit spread. If the stock is at $48 on expiration, then you will lose all the debit.

Hope this helps.

@Victor: Here is the answer to your question:

Ques: If you sell a put at the OTM strike price (e.g. $52.50), won’t the buyer of the put want to exercise it since the strike price is higher than the underlying?Ans: If you are selling a put options which is higher strike than current underlying price, this means, you are selling in the money option. This option price will have two pricing components i.e. Time Value and Intrinsic Value. If the buyer exercises before expiration, he will lose all the time value resulting in a loss to him.

Thus, it will not be a good proposition for the buyer to exercise.

Hope this helps.

Profitable Trading.

[…] Vertical Spread Strategy Explained – … – Vertical Spreads Strategies are one of the most versatile form of option trading strategies. Some of you by now have become really good at Options Trading using … […]

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Thanks for the excellent article Manoj. You mentioned the Bull Call spread is a better approach over Bull Put given similar risk/reward profile given bid/ask slippage advantage, could u explain what is bid/ask slippage and how it differs between the 2 bull spreads?

@Ryan, Actully it should be bull put spread is better as bull call spread as bull call will be in the money and will have wider bid/ask slippage. I will correct that typo.