Chapter 3: Vertical Spreads: directional trades with defined risk
A vertical spread means buying one option and selling another of the same type at the same time, on the same asset and expiration, at two different strike prices. The short option lowers the cost, and the maximum profit and maximum loss are both known before you enter.
| Buy the $880 call (45 days) | Pay $22.50 |
| Sell the $920 call (45 days) | Collect $8.50 |
| Net paid (the cost) | $14 = $1,400 total |
| Max profit | (920−880−14)×100 = 2,600$ |
| Breakeven | 880+14 = $894 (only 2.2% higher) |
Reading the example
- Maximum loss $1,400: if the stock is below $880 at expiration, both options expire worthless, and you lose no more than you paid.
- Maximum profit $2,600: if the stock goes above $920, the long option gains what the short option loses above $920, and you keep the spread width ($40) minus what you paid ($14).
- The profit-to-risk ratio is about 1.9 to 1 (2,600 ÷ 1,400), in exchange for the profit being capped.
Four types, two directions, two methods
| Spread | Outlook | Method |
|---|---|---|
| Bull Call Spread | Rising | Debit Spread |
| Bear Put Spread | Falling | Debit Spread |
| Bull Put Spread | Up or flat | Credit Spread |
| Bear Call Spread | Down or flat | Credit Spread |
In a debit spread you pay at the start and profit if the stock moves your way. In a credit spread you collect at the start and keep what you collected if the stock does not move against you.
Spread width: wider or narrower?
A wider spread (for example 880/960) raises the maximum profit and the cost with it, and a narrower spread (880/900) is cheaper with a cap that is closer. The choice is between the size of the move you expect and what you accept losing.
Before expiration
If the short option is in the money close to expiration, you may be assigned on it. That is why many traders close the whole spread before expiration day instead of letting it expire leg by leg.
Summary
A vertical spread trades some of the possible profit for a lower cost, a closer breakeven and a loss known in advance. Choosing the type starts with your outlook (up or down), then the method (pay or collect). Choosing the width balances the size of the move you expect against the amount you accept losing.
