Vertical Spreads Options Strategies Explained For Newbies | A Simple Way To Understand And Remember Vertical Spreads

I have long avoided using vertical spreads for a few reasons and choose to use simple one-legged options strategies such as selling/ buying PUT/ CALL contracts.

One of the reasons was that I found vertical spreads quite complicated and confusing. Thus, I decided to stick to the most basic of options strategies, that is to buy or sell single-legged options.

However, vertical spreads have their advantages over single-legged options strategies. In this article, I hope to simplify the concepts for you, so you can equip yourself with more tools that can serve you well in different market conditions.

So, What Are Vertical Spreads?

Vertical spreads involve opening up 2 contrasting options contracts (i.e. one buy, one sell), at different strike prices but on the same contract expiration date.

Take, for example, you sell a CALL option on Tesla at $285, expiring on 7 October 2022. At the same time, you also buy a CALL option on Tesla at $275, expiring on 7 October 2022.

What Are The Advantages Of Vertical Spreads?

As vertical spreads involve you buying and selling options contracts at the same time, which means you are paying and receiving premiums simultaneously, the net premium that you need to pay will be lower, as compared to purely single-legged options of buying a CALL/ PUT contract.

On the other hand, vertical spreads will bring in lower premiums as compared to selling single-legged contracts, because you are selling and buying at the same time.

With vertical spreads, you need lower collateral as compared to single-legged options strategies. For example, to sell a PUT contract, the collateral you need to prepare is the amount to buy 100 shares at the strike price, just in case if the contract gets exercised. To sell CALL options, you need to own the shares first before you can sell them.

For vertical spreads, you do not own the shares to be selling CALL options and neither do you need the collateral to buy 100 shares when you are selling PUT options. This is because you are covered by the other leg of the contract where you are buying also CALL/ PUT options.

Lastly, options contract buyers may find theta and IV working against them, i.e they buy at a period of high IV (volatility) and pay a higher premium. When volatility drops, the premium drops as well and they make a loss, despite the share price increasing. This can happen to options sellers too, where they sell at a lower premium and when IV increases, the premium increases. It becomes harder for them to close the contract with a profit.

When an options contract is established, the contract loses time value every day and the option buyer is losing the contract premium even when the share price remains the same.

The theta and IV components of a vertical spread contract tend to cancel out each other. When IV is high, it benefits the sell leg. When IV is low, it benefits the buy leg. The drop in theta (time value) benefits the sell leg but not the buy leg.

What Are The Types Of Vertical Spreads?

There are only 4 types of vertical spreads, two bullish and 2 bearish. Out of the 4 types, two are credit spreads (which means you receive a net premium) and two are debit spreads (which means you pay a net premium).

The 4 vertical spreads are commonly known as:

Bull PUT Spread (aka PUT Credit Spread)

Bull CALL Spread (aka CALL Debit Spread)

Bear PUT Spread (aka PUT Debit Spread)

Bear CALL Spread (aka CALL Credit Spread)

The below diagram summarizes the 4 spreads and the types of contracts to buy and sell. It will be a good reference when you are starting out on spreads.

Understanding & Remembering Vertical Spread

To understand how each vertical spread works, it is important to first understand how the respective options (CALL/PUT) move with the contract strike price and what are the bullish and bearish single-legged strategies.

Buying a CALL option is generally a bullish bet because the CALL buyer wants to lock in the share price, in anticipation that he can earn a profit when the underlying share price rises. The lower the strike price, the more expensive the CALL option will be, because there will be a greater profit margin (between the strike price and the anticipated final increased share price). Thus, the relationship between CALL contract premium and Strike Price (SP) is inversely proportional, I.e. the lower the SP, the higher the premium; the higher the SP, the lower the premium required to buy a CALL options contract. This also explains why OTM CALL options are much cheaper than ITM CALL options.

On the other hand, buying a PUT option is generally a bearish bet, because the PUT buyer wants to lock in the share price, in anticipation that he can earn a profit or hedge his positions when the underlying share price drops.

The lower the strike price, the cheaper the PUT option will be, because there will be a lower profit margin (between the strike price and the anticipated final lower share price). Thus, the relationship between PUT contract premium and Strike Price (SP) is directly proportional, I.e. the lower the SP, the lower the premium; the higher the SP, the higher the premium required to buy a PUT options contract.

What Strategies Are Bullish & What Are Bearish?

When buying CALL options is bullish, the opposite is true as selling CALL is bearish. When buying PUT is bearish; on the other hand, selling PUT is bullish. With this understanding, we can better understand and remember how each spread works.

Each spread will predominately follow the intent (whether bullish or bearish using CALL or PUT). For a start, try to understand the other leg (opposite of the dominant leg) as a helper to lower your collateral, either by providing you the cover in terms of not having to own any shares (when selling CALL options) or less capital upfront to open up the contract (when buying PUT, CALL or selling PUT).

BULL CALL Spread: BULL CALL Spread is actually predominantly buying CALL options. The other leg of selling CALL is to lower the premium required to open up this contract. Since it is predominantly selling CALL, the buyer of this credit spread will need to pay a premium upfront to open up the contract. Thus, a BULL CALL spread is also known as a CALL Debit Spread.

BULL PUT Spread: BULL PUT Spread is actually predominantly selling PUT options. The other leg of buying PUT is to lower the collateral required to open up this contract. Remember, to sell a PUT, you need to have enough collateral to buy 100 shares at the stroke price if the contracts get exercised. Since it is predominantly selling PUT, the buyer of this credit spread will receive a premium upfront to open up the contract. Thus, a BULL PUT spread is also known as a PUT Credit Spread.

BEAR CALL Spread: BEAR CALL Spread is actually predominantly selling CALL options. The other leg of buying CALL is to allow the buyer to open up the contract without having to own the shares or get into a naked CALL contract situation (with unlimited loss). Since it is predominantly selling CALL, the buyer of this credit spread will receive a premium upfront to open up the contract. Thus, a BEAR CALL spread is also known as a CALL Credit Spread.

BEAR PUT Spread: BEAR PUT Spread is actually predominantly buying PUT options. The other leg of selling PUT is to lower the collateral required to open up this contract. Since it is predominantly buying PUT, the buyer of this credit spread will need to pay a premium upfront to open up the contract. Thus, a BEAR PUT spread is also known as a PUT Debit Spread.

I will explain more information about each individual spreads in subsequent posts, such as the maximum gains and maximum losses, and the strike prices to choose to open up the contracts.

Debit Or Credit Spread

I personally am using credit spreads more than debit spreads because I get to receive the premium upfront, instead of having to fork out premiums to open up the contract. Also, time decay benefits the credit spreads options contracts because as the contract runs down toward the expiry date, time decay means the premium decreases even if the price stays sideways. However, do bear in mind that if the contract becomes Out-Of-The-Money (OTM), time works against the contract owners even if it is a credit spread. So, always try to ensure your credit spreads are In-The-Money (ITM) to benefit from the time decay of Vertical Credit Spreads.

I hope this sharing is useful, especially to the newbies, and do stay tuned for more elaborated posts of each vertical spread.

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