Which Vertical Option Spread Should You Use?

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 option strategies. Yet, to deploy these strategies effectively, you also need to develop an understanding of which option spread to use in a given trading environment or specific stock situation. First, let’s recap the main features of the four basic vertical spreads.

Each vertical spread involves buying and writing puts or calls at different strike prices. Each spread has two legs, where one leg is buying an option, and the other leg is writing an option. 

This can result in the option position (containing two legs) giving the trader a credit or debit. A debit spread is when putting on the trade costs money. For example, one option costs $300 but the trader receive $100 from the other position. The net premium cost is a $200 debit.

If the situation were reversed, and the trader receives $300 for putting on an option trade, and the other option costs $100, the two option contracts combine for a net premium credit of $200.

Here is how each spread is executed.

A bull call spread is 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. Since this is a debit spread, the maximum loss is restricted to the net premium paid for the position, while 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.

A bear call spread is selling a call option, and simultaneously purchasing another call option with the same expiration date but at a higher strike price. Since this is a credit spread, the maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the calls less the net premium received.

A bull put spread is writing a put option, and simultaneously purchasing another put option with the same expiration date but a lower strike price. Since this is a credit spread, the maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the puts less the net premium received.

A bear put spread is purchasing a put option, and simultaneously selling another put option with the same expiration date but a lower strike price. Since this is a debit spread, the maximum loss is restricted to the net premium paid for the position, while 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.

The table below summarizes the basic features of these four spreads. Commissions are excluded for simplicity.

Vertical spreads are used for two main reasons:

• For debit spreads, to reduce the premium amount payable.
• For credit spreads, to lower the option position's risk.

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, when compared to the profit potential of a stand-alone call or put, it also substantially reduces the position's cost. Such spreads can therefore be easily used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg.

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 or 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.

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 has elevated volatility due to a recent plunge.

Consider using a bear call spread when volatility is high and 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. 

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, but because a credit was received this 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.

Consider using a bear put spread when 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, like to hedge long positions after a strong bull market.

The following factors may assist in coming up with an appropriate options/spread strategy for the current conditions and your outlook.

• Bullish or bearish: Are you positive or negative on the markets? If you are very bullish, you might be better off considering stand-alone calls (not a spread). But if you are expecting modest upside, 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, 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: Is your preference is for limited risk with potentially greater reward, this 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 mentality.

Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, 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, you should opt for a bull put spread.

The table above outlined whether the bought option is above or below the strike price of the written option. Which strike prices are used is dependent on the trader's outlook. For example, on a bull call spread, if the price of a stock is likely to stay around $50 until the options expire, you may buy a call with a strike near $50 or and a sell a call at $55. If the stock is unlikely to move much, selling a call at the $60 strike makes 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 call, but there is less chance the price will move above $52 or $53 compared to $50.

There is always a tradeoff. Before taking a spread trade consider what is being given up or gained 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 being attained is miniscule, and likelihood of losing is high, then a more balanced approach should be considered.

Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading. Look at the current market conditions and consider your own analysis. Determine which of the vertical spreads best suits the situation, if any, then consider which strike prices to use before pulling the trigger on a trade.