Vertical spreads are the building blocks for many options strategies. If you're new to options trading, vertical spreads may seem intimidating. However, this versatile and straightforward strategy can be a great tool once you understand the basics.
In this complete guide to vertical spreads, we'll explain everything you need to know about bullish and bearish spreads, including how to set them up properly, how to create an iron condor, and how to adjust spread positions.
What is a vertical spread?
A vertical spread options strategy involves buying and selling two options with different strike prices and the same expiration date. The options can be call or put options but must be the same type.
The difference between the two options' strike prices is called the spread width. The vertical spread strategy gets its name because the strike price distance is vertical on a standard options chain. The spread width determines a vertical spread’s risk/reward profile.
For example, the spread width between the $100 strike price and the $110 strike price is $10 wide.
Bullish vertical spread
A vertical spread can be bullish or bearish.
A bull call spread is created when the investor buys a call option and sells a higher strike call option with the same expiration date. Bullish vertical call spreads are opened for a debit and are also called call debit spreads. The strategy profits from an increase in the underlying asset’s price.
- Buy-to-open: $50 call
- Sell-to-open: $55 call
Similarly, vertical put credit spreads are a bullish strategy that involves selling a put option and buying a lower strike put option with the same expiration date. Bull put spreads receive a credit at entry and are also called put credit spreads.
- Sell-to-open: $50 put
- Buy-to-open: $45 put
Bearish vertical spread
A bearish vertical call spread is created when the investor sells a call option and buys a higher strike call option with the same expiration date. Bearish vertical call spreads are entered for a credit and are also called call credit spreads. The strategy profits from a decrease in the underlying asset’s price.
- Sell-to-open: $50 call
- Buy-to-open: $55 call
Vertical put debit spreads are bearish and are created when an investor buys a put option and sells a put option with a lower strike price and the same expiration date.
- Buy-to-open: $50 put
- Sell-to-open: $45 put
Is a vertical spread the same as a debit spread?
Not all vertical spreads are debit spreads. A debit spread is a type of vertical spread. A vertical spread can be either a long vertical spread or a short vertical spread. Long vertical spreads are debit positions, while short vertical spreads are credit positions.
A long vertical spread is also known as a debit spread because the trader pays money to enter the trade. Short vertical spreads are also known as credit spreads because the trader receives a credit when entering the trade.
All vertical spreads have defined profit and loss outcomes. The initial premium received when opening a credit spread is the position’s max potential profit. The initial debit paid when opening a debit spread is the position’s max loss.
The max loss for a credit spread is calculated by subtracting the spread width from the credit received.
For example, if a $5 wide bull put credit spread collects $1.00 of credit, the maximum loss is $400 if the stock price is below the long put at expiration.
The max profit for a debit spread is calculated by subtracting the debit paid from the spread width.
For example, if a $5 wide bull call debit spread costs $2.00, the maximum profit is $300 if the stock price is above the short call at expiration.
Diagonal vs. vertical spread
A diagonal spread is an options strategy that involves buying and selling two options with different strike prices and different expiration dates.
The main difference between a vertical and diagonal spread is the expiration date. With a vertical spread, the options have the same expiration date. With a diagonal spread, the options have different expiration dates.
The outlook for a diagonal spread is similar to a vertical spread. Bullish diagonal spreads profit from an increase in the underlying asset’s price, while bearish diagonal spreads benefit from a decrease in the underlying asset’s price.
Iron condor vs. vertical spread
An iron condor combines two vertical credit spreads: a bull put spread sold below the stock price, and a bear call spread sold above the stock price. All the options have the same expiration date.
- Buy-to-open: $90 put
- Sell-to-open: $95 put
- Sell-to-open: $105 call
- Buy-to-open: $110 call
The main difference between an iron condor and a vertical spread is that an iron condor has four legs (options), while a vertical spread only has two legs (options).
Another difference is that iron condors are credit spreads, while vertical spreads can be either debit or credit spreads.
Iron condors are typically set up as neutral strategies where the goal is to make money if the underlying asset's price stays within a specific range (between the short call and short put option).
Vertical spread break-even price
The break-even price for a vertical spread considers the difference between the spread's two strike prices and the credit received or debit paid at trade entry.
For example, a put credit spread that collects $1.00 of premium would have a break-even price $1.00 below the short put strike.
For a put debit spread, the outcomes are reversed. If you pay $1.00 to enter a bear put spread, the break-even price would be $1.00 below the long put strike. The underlying security would need to decrease by at least $1.00 to generate a profit.
Vertical spreads at expiration
What happens to a vertical spread at expiration depends on if the spread was a credit spread or a debit spread and the underlying's price at expiration relative to the strike prices.
Nothing happens if a put or call credit spread’s short strike expires out-of-the-money. Both options expire worthless, and you keep the entire premium you received.
If the stock price is above or below the short strike price at expiration, you may be assigned shares. However, if the stock is above or below the long option’s strike price, the two options will be exercised and cancel each other out. You will realize the max loss for the position.
For example, if you sold a $5 wide bear call credit spread at $50/$55 for $1.00, and the underlying security closed above the long call at expiration, your broker would sell shares at $50 and buy shares at $55.
The loss would be $400 per contract on the position ($50 - $55 = -$5 +$1 = -$4 x 100 per contract = -$400).
If a put or call debit spread expires out-of-the-money, nothing happens. Both options expire worthless, and you forfeit the entire premium you paid for a full loss. If the long option expires in-the-money, you can exercise the option and receive shares at the option’s strike price.
If the underlying security is above or below the short strike price at expiration, you could exit the position for a max profit, or let your broker exercise the options (typically for a cost). It is recommended that you manually close positions that expire in-the-money.
You can always exit positions prior to expiration to avoid exercise and assignment.
*Check with your broker for specifics regarding expired ITM options.
Rolling a vertical spread
You can roll a vertical spread by closing your current position and opening a new position with a later expiration date. Rolling a spread typically brings in more credit, which reduces your risk, extends the break-even price, and gives the position more time to move in your favor.
The decision to roll a vertical spread depends on your outlook for the underlying security and currently trading.