Vertical Spreads

Vertical spreads are directional option strategies which involve two options of the same type, same expiration, and different strikes. There are four possible vertical spreads: bull call spread, bear put spread, bear call spread, and bull put spread. This page explains what they have in common, how they differ, and which vertical spread strategies to use in different situations.

Defining Characteristics

The following criteria define vertical spreads:

• Two legs.
• One long and one short (hence spread).
• Same size (same number of contracts).
• Same option type (either two calls or two puts).
• Same expiration.
• Different strikes.

If an option position meets all the above criteria, it is a vertical spread.

If one or more is not true, it is not. For instance, spreads with different strikes and different expirations are called diagonal spreads; spreads with same strike and different expirations are time or calendar spreads; when the two legs have different number of contracts, it is a ratio spread or backspread.

Why They Are Called Vertical

The name "vertical" refers to the fact that the two options in the spreads differ by strike price. It is based on the traditional way option quotes are presented, with strikes in rows (vertically) and expirations in columns, or more recently in tabs on a computer screen (horizontally).

Other kinds of option spreads are horizontal spreads (also called calendar spreads or time spreads), where the two options have the same strike and differ by expiration date, and diagonal spreads, where the two options differ in both strike and expiration.

Four Possible Vertical Spreads

Based on the criteria above, there can be only four types of vertical spreads.

The position can be made either with two calls (vertical call spread) or two puts (vertical put spread).

It can be long the lower strike and short the higher strike, or vice-versa.

The four vertical spreads are:

• Bull call spread = long lower strike call + short higher strike call
• Bull put spread = long lower strike put + short higher strike put
• Bear call spread = short lower strike call + long higher strike call
• Bear put spread = short lower strike put + long higher strike put

Bull vs. Bear Vertical Spreads

The bull and bear in the spread names refer to directional exposure:

Bull call spread and bull put spread are "bullish" – make money when the underlying goes up and lose when it goes down.

Bear call spread and bear put spread are "bearish" – profit when underlying price declines.

Order of Strikes Decides Direction

Notice in the list of the four strategies above that the two bull spreads are both long the lower strike and short the higher strike. The two bear spreads are both long the higher strike and short the lower strike.

The directional exposure to either rising or falling underlying price is not decided by option type (call or put), but by the order of strikes alone – which strike is long and which is short.

This may be surprising, but it is also very useful for remembering how all the four spreads are built:

Bullish – price goes up – from lower strike (long) to higher strike (short).

Bearish – price goes down – from higher strike (long) to lower strike (short).

Credit vs. Debit Vertical Spreads

The above said, whether you choose calls or puts does make a difference. It decides cash flow.

There are two types of option strategies – credit and debit – based on initial cash flow when opening the position.

You need to pay some cash when opening a debit strategy, because the (long) options being bought are more expensive than the (short) options being sold.

Conversely, you get paid when opening a credit strategy, because the options you sell are more expensive than those you buy.

This does not mean that credit spreads are better than debit spreads. The opening transaction is only one part of the trade, and initial cash flow is only one part of total profit or loss. There is no automatic edge making either credit or debit strategies better by default. Moreover, the positive initial cash flow from credit strategies typically goes hand-in-hand with margin requirements.

Back to vertical spreads:

• Bull call spread and bear put spread are debit vertical spreads.
• Bear call spread and bull put spread are credit vertical spreads.

Why?

When opening a bull call spread, you buy a lower strike call and sell a higher strike call. The former is more expensive than the latter (calls get out of the money and become less expensive with increasing strikes). Therefore, the amount you receive for selling the higher strike call is not enough to pay for buying the lower strike call, and net initial cash flow is negative.

With bear put spread, you are buying the higher strike, but puts become more expensive as strike increases. So you are again buying (paying for) the more expensive option and selling (get cash for) the less expensive option.

However, the cash flow is opposite with bear call spread and bull put spread, as you are buying the cheaper option and selling the more expensive one. These spreads have positive initial cash flow, but they also require margin.

Payoff at Expiration

Why credit vertical spreads require margin, but debit spreads don't?

The reason is what happens (or can happen) at expiration. Or more generally, the risk of each spread.

With all vertical spreads, there are three possible scenarios at expiration:

1. Both options are in the money
2. One option is in the money and the other expires worthless
3. Both options expire worthless

When your long option ends up in the money at expiration, you get paid. You can exercise it for a gain equal to the difference between underlying price and the option's strike. It adds to the trade's total profit.

When your short option ends up in the money, its value is also the difference between underlying price and strike, but this time you are short, you get assigned, and the option's value adds to the trade's total loss.

Debit Vertical Spread Payoff

With debit vertical spreads (bull call spread and bear put spread), whenever your short option is in the money, your long option is too – and more so (by exactly the difference between the two strikes). Therefore you can't lose at expiration:

• If both options are in the money, you get the strike difference.
• If only your long option is in the money, you get the difference between underlying price and its strike.
• If both options are out of the money, nothing happens, they just expire.

With debit spreads, the worst case scenario at expiration is zero. You may or may not gain something at expiration, but in any case you can't lose. Maximum possible total loss from the trade is what you have paid when opening the spread. Maximum possible profit is strike difference (if both options are in the money at expiration) minus initial cost.

Credit Vertical Spread Payoff

With credit spreads (bear call spread and bull put spread) it is different. Now, due to the order of strikes, whenever your long option is in the money, your short option is too, and more. Same logic as above, but now you are on the wrong side:

• If both options are in the money, you lose the strike difference.
• If only your short option is in the money, you lose the difference between underlying price and strike.
• If both are out of the money, nothing happens.

Best case scenario with credit vertical spreads is that both options expire worthless. Maximum possible profit equals the positive initial cash flow – the net premium received when opening the spread. With credit spreads, you are "defending the net premium collected". You "sell" the spread for some cash and hope that it will become less valuable, ideally worthless, at expiration. Maximum risk is when both options expire in the money, and total loss will be strike difference minus net premium received.

Long vs. Short Vertical Spreads

In light of the above, sometimes vertical spreads are called long (debit spreads – you buy a spread and want it to become more valuable) and short (credit spreads – you sell a spread and want it to become less valuable).

• Bull call spread is also called long call spread
• Bear put spread = long put spread
• Bear call spread = short call spread
• Bull put spread = short put spread

Note the names long and short do not refer to underlying direction (not with the put spreads). Long put spread is bearish. It is called long, because you are long the more valuable option (the higher strike put). You pay cash when opening the spread and want it to become more valuable. Conversely, short put spread is bullish; it is called short because you are short the more valuable higher strike put, and you get cash for "selling" the spread.

Practical Trading Tips

Continue to more details and practical trading tips (such as which strikes to select) for individual strategies:

• Bull call spread
• Bear put spread
• Bear call spread
• Bull put spread