Basic Vertical Option Spreads: Which to Use?

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Basic Vertical Option Spreads: Which to Use?

Spread

Strategy

Strike Prices

Debit / Credit

Max. Gain

Max. Loss

Break-Even

Bull Call

Buy Call C1
WriteCall C2

Strike price of C2 > C1

Debit

(C2 − C1) − Premium paid

Premium paid

C1 + Premium

Bear Call

WriteCall C1
Buy Call C2

Strike price of C2 > C1

Credit

Premium received

(C2 − C1) − Premium received

C1 + Premium

Bull Put

WritePut P1
Buy Put P2

Strike price of P1 > P2

Credit

Premium received

(P1 − P2) − Premium received

P1 − Premium

Bear Put

Buy Put P1
WritePut P2

Strike price of P1 > P2

Debit

(P1 − P2) − Premium paid

Premium paid

P1 − Premium

Credit and Debit Spreads

Vertical spreads are used for two main reasons:

  1. To lower the premium amount due on debit spreads.
  2. To reduce the risk of the option position in credit spreads.

Let’s start with the first point. Option premiums may be highly costly when general market volatility is high, or when the implied volatility of a given stock is high. While a vertical spread limits the greatest profit potential of an option strategy when compared to the profit potential of a stand-alone call or put, it also significantly decreases the position’s cost.

Such spreads may therefore be employed simply during times of high volatility, since volatility on one leg of the spread will counteract volatility on the other.

Credit spreads may considerably lower the risk of writing options since option writers take on large risk in order to collect a relatively little amount of option premium. Many good option transactions might be wiped out by a single bad trade. In fact, option writers are often disparaged as those who descend to pick pennies on the railway track. They do so gladly—until a train comes along and runs them over.

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Writing naked or uncovered calls is one of the riskiest option strategies since the potential loss is potentially infinite if the deal goes wrong. Writing options is less dangerous, but an aggressive trader who had written puts on many equities would be left with a big number of pricy stocks if the market crashed suddenly. Credit spreads limit this risk, but at a lesser cost in terms of option premium.

Which Vertical Spreadto Use

When calls are costly owing to high volatility and you anticipate modest returns rather than large profits, consider employing a bull call spread. This situation is common in the final stages of a bull market, when equities are reaching their top and gains are more difficult to attain. A bull call spread might also be useful for a company with high long-term potential but high volatility owing to a recent drop.

When volatility is strong and a moderate drop is likely, consider utilizing a bear call spread. This situation is common in the closing phases of a bear market or correction, when equities are reaching a bottom but volatility remains excessive due to pessimism.

Consider employing a bull put spread to make a premium income in sideways to moderately higher markets, or to purchase stocks at a discount when markets are volatile. Buying stocks at lower prices is conceivable since the written put may be executed to purchase the stock at the strike price, but because a credit was earned, the cost of purchasing the shares is decreased (compared to if the shares were bought at the strike price directly).

When there is a quick bout of volatility but the underlying trend is still upward, this method is particularly ideal for accumulating high-quality equities at low prices. A bull put spread is similar to “buying the dips,” but with the extra benefit of collecting premium money.

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Consider employing a bear put spread when a company or index is projected to fall moderately to significantly and volatility is high. Bear put spreads may also be used to minimize the dollar amounts of premiums paid during times of low volatility, such as when hedging long positions following a big bull market.

Factors to Consider

The following considerations may help you develop a proper options/spread strategy for the present situation and your perspective.

  • Bullish or bearish: Are you bullish or bearish on the market? If you are really bullish, you may be better suited contemplating stand-alone calls (not a spread).Consider a bull call spread or a bull put spread if you predict a moderate gain. Similarly, if you are mildly bearish or wish to lower the cost of hedging your long holdings, the bear call spread or bear put spread might be the solution.
  • Volatility outlook: Do you believe volatility will grow or fall? Rising volatility may benefit option buyers, favoring debit spread tactics. The option writer’s probabilities rise when volatility falls, which favors credit spread techniques.
  • Risk vs reward: If you choose a low risk with a possibly higher payoff, you are more of an option buyer. If you prefer a little return for a potentially higher risk, you are more in line with the option writer’s mindset.

Based on the above, a bear put spread would be the optimal approach if you are mildly pessimistic, believe volatility is growing, and desire to reduce your exposure. If, on the other hand, you are somewhat positive, believe volatility is declining, and are comfortable with the risk-reward payout of writing options, you should consider a bull put spread.

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Which Strike Prices to Choose

The table above shows whether the purchased option is more than or less than the strike price of the written option. The strike prices chosen are determined by the trader’s view.

For example, if the price of a stock is expected to remain around $55 until the options expire, you may purchase a call with a strike at 50 and sell a call at the 55 strike. If the stock is unlikely to move substantially, selling a 60-strike call makes less sense due to the lesser premium earned. Purchasing a call with a strike of 52 or 53 is less expensive than purchasing a call with a strike of 50, but the lower strike provides less downside protection.

There is always a cost. Consider what you are giving up or gaining by using various strike prices before entering a spread trade. Consider the chances of achieving the greatest possible gain or suffering the greatest possible loss. While it is feasible to design trades with huge theoretical profits, if the possibility of achieving that gain is low and the risk of losing is great, a more balanced strategy should be explored.

The Bottom Line

Knowing which option spread strategy to utilize in various market situations may boost your chances of success in options trading dramatically. Consider the current market circumstances as well as your own analyses. Determine which vertical spreads, if any, best fit the scenario, and then determine the strike prices to utilize before entering a transaction.

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