Which Vertical Option Spread Should You Use?

Vertical spreads are a popular option trading strategy that can create income or limit risk. There are several different types of vertical spreads, each unique characteristic. This article will explore the four most common types of vertical spreads and help you determine which one is right for you.

Basic Features of Vertical Spreads

Vertical spreads involve buying and selling options of the same type. However, vertical spreads come with different strike prices. The option spread has the same expiration date. In addition, the profit is limited to the difference between the strike prices minus the cost of both options.

Types of Vertical Spreads

Bull Call Spread

The bull call spread is a bullish strategy that involves buying one option and selling another to reduce the cost of entering into a long position. It typically profits when the price of an underlying stock moves higher, increasing the value of both options.

Bear Put Spread

The bear put spread is a neutral-to-bearish strategy that involves buying one option and selling another to reduce the cost of entering into a short position. It typically profits when the price of an underlying stock moves lower, thereby increasing the value of both options.

Covered Call

The covered call is a bullish strategy that involves owning shares of an underlying stock and writing (selling) one-call option for every 100 shares. It typically profits when the price of an underlying stock moves higher, increasing the value of both options and offsetting most or all potential losses on the stocks owned by this strategy.

Protective Put

The protective put is a neutral-to-bullish strategy that involves buying one put option to protect against a significant decline in the price of an underlying stock. It typically profits when the price of an underlying stock moves lower, thereby increasing the value of both options and offsetting most or all potential losses on stocks owned by this strategy.

Credit and Debit Spreads

The key difference between credit and debit spreads is the initial cash outlay. A credit spread entails buying an option and selling another option of the same type, with both options having the same expiration date. The initial cash outlay is received when entering into the trade.

Conversely, a debit spread entails buying one option and selling another option of the same type, with both options having the same expiration date. The initial cash outlay is paid when entering into the trade.

The maximum gain for a credit spread equals the difference between two strike prices minus the total cost of buying and selling each option (debit). A debit spread has unlimited profit potential if it’s profitable at expiration since it can be sold at the same price as the initial debit.

Which Vertical Option Spread Should You Use?

Consider using the bull call spread when bullish on the underlying stock and generating income. The bear put spread is a good choice if you’re neutral-to-bearish on an underlying stock and looking for limited risk with potential gains. Use the covered call strategy as part of your overall equity portfolio management plan. Alternatively, use a covered call strategy specifically to boost returns by writing (selling) call options against your existing stocks.

The protective put is a good choice when you want to protect the value of your stock portfolio from potential losses. Finally, use the credit and debit spreads as an overall strategy for generating income or hedging portfolios.

Factors to Consider

Factors you should consider when selecting what vertical spread include the purpose of trade (income or limit risk), underlying security, and expiration date of options. Other factors include the amount of capital available, the time frame for trade, and risk tolerance.

There are a variety of vertical spreads to choose from, and each has its benefits and risks. Consider your situation and the factors listed above when making your decision. Make sure you understand the risks before entering into any trade.