Which Vertical Option Spread Should You Use?

By Elvis Picardo, CFA AAA

Understanding the features of the four basic types of price spreads or vertical spreads – bull call, bear call, bull put and bear put – is a great way to further your learning about relatively advanced option strategies. But to deploy these strategies to maximum effect, 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.

Basic Features of Vertical Spreads

  • 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. 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.
  • Bear call spread: Involves selling a call option and simultaneously purchasing another call option with the same expiration date but 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.
  • Bull put spread: Involves writing or short selling 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.
  • Bear put spread: Involves 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).

Spread

Strategy

Strike Prices

Debit / Credit

Max. Gain

Max. Loss

Break-Even

Bull Call

Buy Call C1

Sell (Write) Call C2

Strike price of C2 > C1

Debit

(C2-C1) – Premium paid

Premium paid

C1 + Premium

Bear Call

Sell (Write) Call C1

Buy Call C2

Strike price of C2 > C1

Credit

Premium received

(C2-C1) – Premium received

C1 + Premium

Bull Put

Sell (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

Sell (Write) Put P2

Strike price of P1> P2

Debit

(P1-P2) – Premium paid

Premium paid

P1 - Premium

Why Use a Spread?

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 first. 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 certainly 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, and who 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.

So Which Spread Should You Use?

  • Consider using a bull 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. This was the environment that prevailed in the second half of 2007, when global equities were peaking even as concerns about the U.S. housing market were rapidly escalating. 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. This was the environment seen in the first quarter of 2009, when stocks were still declining but comparatively slower than in the plunge of 2008, while high volatility enabled healthy levels of premium income to be earned.
  • Consider using a bull put spread to earn premium income in sideways to marginally higher markets, or to buy stocks at effective below-market prices when markets are choppy. 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. The market correction sparked by the U.S. credit downgrade in the summer of 2011 is a perfect example of an environment when this strategy would have paid off handsomely. A bull put spread is akin to “buying the dips” (purchasing after a price decline) 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, as was the case in the first half of 2008. Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid; as, for example, to hedge long positions after a strong bull market like in the first quarter of 2014.

Factors to Consider

The following factors may assist in coming up with an appropriate options/spread strategy for the broad markets:

  • 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. 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 (i.e. put on a debit spread), while declining volatility improves the odds for the option writer (i.e. initiate a credit spread).
  • Risk versus reward: Is your preference for limited risk with potentially greater reward (the payoff profile for an option buyer), or for limited reward for possibly greater risk (the payoff for an option writer)?

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 Bottom Line

Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.

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