Understanding the features of the four basic types of vertical spreads—bull call, bear call, bull put, and bear put—is a great way to further your learning about relatively advanced options strategies.
Yet to deploy these strategies effectively, you also need to develop a thorough understanding of which option spread to use in a given trading environment or specific stock situation.
First, let’s review the main features of the four basic vertical spreads.
Key Takeaways
- Option spreads are common strategies used to minimize risk or to bet on various market outcomes using two or more options.
- In a vertical spread, an individual simultaneously purchases one option and sells another (on the same underlying asset) at a higher strike price using both calls or both puts.
- A bull vertical spread profits when the underlying stock's price rises.
- A bear vertical spread profits when the underlying stock's price falls.
Basic Features of Vertical Spreads
Each vertical spread involves buying and writing puts or calls at different strike prices. Each spread has two legs. For one leg you buy an option, and for the other leg you write an option.
This can result in an option position (containing two legs) that gives the trader a credit or debit. A debit spread is one that costs the trader money. For example, one option costs $300, but the trader receives $100 from selling the option in other position. The net premium cost is a $200.
The reverse situation, where the trader receives $300 for putting on an option trade and spends $100 for the other option, results in a net premium credit of $200.
Types of Vertical Spreads
Here is how each spread is executed:
- A bull call spread involves purchasing a call option, and simultaneously selling another call option (on the same underlying asset) with the same expiration date but a higher strike price. This is a debit spread, with the maximum loss restricted to the net premium paid for the position. The maximum profit is equal to the difference in the strike prices of the calls less the net premium paid to put on the position.
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- A bear call spread involves selling a call option, and simultaneously purchasing another call option with the same expiration date but at a higher strike price. This is a credit spread, with the maximum gain restricted to the net premium received for the position. The maximum loss is equal to the difference in the strike prices of the calls less the net premium received.
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- A bull put spread involves writing a put option, and simultaneously purchasing another put option with the same expiration date but a lower strike price. This is a credit spread, with the maximum gain restricted to the net premium received for the position. The maximum loss is equal to the difference in the strike prices of the puts less the net premium received.
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- A bear put spread involves purchasing a put option, and simultaneously selling another put option with the same expiration date but a lower strike price. This is a debit spread, where the maximum loss is restricted to the net premium paid for the position. The maximum profit is equal to the difference in the strike prices of the puts less the net premium paid to put on the position.
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The table below summarizes the basic features of these four spreads. Commissions are excluded for simplicity.
Spread |
Strategy |
Strike Prices |
Debit / Credit |
Max. Gain |
Max. Loss |
Break-Even |
Bull Call |
Buy Call C1 Write Call C2 |
Strike price of C2 > C1 |
Debit |
(C2 − C1) − Premium paid |
Premium paid |
C1 + Premium |
Bear Call |
Write Call C1 Buy Call C2 |
Strike price of C2 > C1 |
Credit |
Premium received |
(C2 − C1) − Premium received |
C1 + Premium |
Bull Put |
Write Put P1 Buy Put P2 |
Strike price of P1 > P2 |
Credit |
Premium received |
(P1 − P2) − Premium received |
P1 − Premium |
Bear Put |
Buy Put P1 Write Put P2 |
Strike price of P1 > P2 |
Debit |
(P1 − P2) − Premium paid |
Premium paid |
P1 − Premium |
Credit and Debit Spreads
Vertical spreads are used for two primary reasons:
- To reduce the premium amount payable (debit spreads).
- To lower the option position’s risk (credit spreads).
Reduce Premium Cost
Let’s evaluate the first point. Option premiums can be quite expensive when overall market volatility is elevated, or when a specific stock’s implied volatility is high. While a vertical spread caps the maximum gain that can be made from an option position, compared to the profit potential of a stand-alone call or put, it also substantially reduces the position’s cost.
Thus, such spreads can be used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg.
Lower Risk
As far as credit spreads are concerned, they can greatly reduce the risk of writing options, since option writers take on significant risk to pocket a relatively small amount of option premium. One disastrous trade can wipe out positive results from many successful option trades. In fact, option writers are occasionally disparagingly referred to as individuals who stoop to collect pennies on the railway track. They happily do so—until a train comes along and runs them over.
Writing naked (uncovered) calls is among the riskiest option strategies, since the potential loss if the trade goes awry is theoretically unlimited. Writing puts is comparatively less risky, but an aggressive trader who has written puts on numerous stocks would be stuck with a large number of pricey stocks in a sudden market crash. Credit spreads mitigate this risk, although the cost of this risk mitigation is a lower amount of option premium.
Which Vertical Spread to Use
Bull Call Spread
Consider using a bull call spread when calls are expensive due to elevated volatility and you expect moderate upside rather than huge gains. This scenario is typically seen in the latter stages of a bull market, when stocks are nearing a peak and gains are harder to achieve.
A bull call spread can also be effective for a stock that has great long-term potential but elevated volatility due to a recent plunge.
Bear Call Spread
Consider using a bear call spread when volatility is high and a modest downside is expected. This scenario is typically seen in the final stages of a bear market or correction, when stocks are nearing a trough but volatility is still elevated because pessimism reigns supreme.
Bull Put Spread
Consider using a bull put spread to earn premium income in sideways to marginally higher markets, or to buy stocks at reduced prices when markets are choppy. Buying stocks at reduced prices is possible because the written put may be exercised to buy the stock at the strike price. The credit received reduces the cost of buying the shares (compared to if the shares were bought at the strike price directly).
This strategy is especially appropriate to accumulate high-quality stocks at cheap prices when there is a sudden bout of volatility but the underlying trend is still upward. A bull put spread is akin to “buying the dips,” with the added bonus of receiving premium income in the bargain.
Bear Put Spread
Consider using a bear put spread when a moderate to significant downside is expected in a stock or index and volatility is rising. Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid. For example, if you're seeking to hedge long positions after a strong bull market.
There is always a trade-off. Before establishing a spread trade, consider what you give up or gain by choosing different strike prices. Consider the probabilities that the maximum gain will be attained or that the maximum loss will be taken. While it is possible to create trades with high theoretical gains, if the probability of that gain is minuscule, and if the likelihood of losing is high, then consider a more balanced approach.
Factors to Consider
The following factors may assist you in coming up with an appropriate options/spread strategy for existing conditions and your outlook on the market.
- Bullish or bearish: Are you positive or negative on the markets? If you are very bullish, then you might be better off considering stand-alone calls (not a spread). But if you are expecting a modest upside, then consider a bull call spread or a bull put spread. Likewise, if you are modestly bearish or want to reduce the cost of hedging your long positions, then the bear call spread or bear put spread may be the answer.
- Volatility view: Do you expect volatility to rise or fall? Rising volatility may favor the option buyer, which favors debit spread strategies. Declining volatility improves the odds for the option writer, which favors credit spread strategies.
- Risk versus reward: A preference for limited risk with potentially greater reward is more an option buyer’s mentality. If you seek limited reward for possibly greater risk, this is more in line with the option writer’s mentality.
Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, then the best strategy would be a bear put spread.
Conversely, if you are moderately bullish, think volatility is falling, and are comfortable with the risk-reward payoff of writing options, then you should opt for a bull put spread.
Which Strike Prices to Choose
The table above outlined whether the bought option is above or below the strike price of the written option. Which strike prices to use depends on a trader’s outlook on the market.
For example, with a bull call spread, if the price of a stock is likely to stay around $55 until the options expire, then you may buy a call with a strike near 50 and sell a call at the 55 strike. If the stock is unlikely to move much, then selling a 60-strike call makes a bit less sense because the premium received will be lower. Buying a call with a 52 or 53 strike would be cheaper than buying the 50-strike price call, but there is greater downside protection with the lower strike.
Who Is a Vertical Spread for?
Vertical spreads are useful to options traders who want to benefit from specific directional market moves and also limit their financial risk.
Is a Vertical Spread a Hedge?
Yes, you're hedging your bet by buying and selling the same option type. You're taking positions on both sides of the market so that, while you hope to make money on one side, the other side protects you from the risk of losing too much money if the market moves contrary to your outlook. While useful, the downside of a hedge is that any profit gained from one position is reduced by the loss from the other.
Why Is the Spread Referred to As Vertical?
The term "vertical" refers to the higher and lower strike prices. One is above, the other is below. A spread can be horizontal, where the strike prices are the same but the expiration dates are different.
The Bottom Line
A vertical option spread is the simultaneous purchase and sale of the same option type (a call or a put) with the same expiration date but with different strike prices.
Understanding which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.
Look at current market conditions and consider your own analysis. Before pulling the trigger on a trade, determine which vertical spread, if any, best suits the situation and then consider which strike prices make the most sense.