Once the trader new to options grasps basic option-buying and selling strategies (discussed in Naked Call Writing and Going Long on Calls), as well as important pricing dimensions, it's time to move to an intermediate level of trading knowledge. This article introduces the vertical credit spread, which comes in two shapes: the bull put spread and the bear call spread. (See also: The Importance of Time Value and The ABCs of Option Volatility)
The vertical credit spread offers traders an excellent limited-risk strategy that can be used with equity as well as commodity and futures options. These trades, which are contrary to debit spreads, essentially profit from the decay of time value, and they don't require any movement of the underlying to produce a profit. Let's start by quickly reviewing what we mean by a credit spread. (See also: Options for Beginners.)
Since we are simultaneously buying and selling options having two different strikes, there is an outlay of cash upon purchasing one side of the spread and a simultaneous receipt of option premium when selling the other side (that is, the short side). And these basic credit spreads are constructed in equal combinations.
Simultaneously buying and selling options with different strike prices establishes a spread position. And when the option sold is more expensive than the option bought, a net credit results. This is known as a vertical credit spread. By "vertical" we simply mean that the position is built using options with the same expiration months. We are simply moving vertically along the option chain (the array of strike prices) to establish the spread in the same expiration cycle.
Vertical Credit Spread Properties
Vertical credit spreads can be either bear call spreads or bull put spreads. While at first this may sound confusing, an examination of each of the "legs," or each side of the spread, will clarify. Vertical spreads typically have two legs: the long leg and the short leg.
The key to determining whether the vertical spread is a debit or credit spread is to look at the legs that are sold and purchased. As you will see in the examples below, when the leg that is sold is closer to the money, the vertical spread becomes a credit spread and is generally a net credit representing only time value. A debit spread, on the other hand, always has the short option in the combination farther away from the money, so the debit spread is a net buying strategy.
Exhibit 1 above contains the essential properties of the credit-spread strategy. Let's look at the trade setup, strike order, debits/credits and profitable conditions using an example first of a bull put spread then of a bear call spread. Exhibit 2 contains a profit/loss function for a coffee bull put spread.
In Exhibit 2 below, we have July coffee trading at 58 cents, which is indicated by the black triangle along the horizontal axis. The profit/loss function is the solid blue line on which each kink represents a strike price (we will ignore the dashed functions, which represent profit/loss at different time intervals during the life of the trade). Recall that in a bull put spread, just as with a bear call spread, we are selling the more expensive option (the one closer to the money) and buying the option with a strike farther away from the money (the less expensive one). This will create a net credit.
Exhibit 2: Coffee Bull Put Spread
Created using OptionVue5 Options Analysis Software. This example excludes commissions and fees, which can vary from broker to broker
By selling the coffee option with a higher put strike of 55 ($0.029, or $1,087.50) and simultaneously buying the coffee option with a lower put strike of 50 (for $0.012, or $450), we generate a net credit of $637.50 with this bull put spread. Note that each penny of an option on coffee futures is worth $375. As long as at expiration July coffee trades at or above the upper strike of 55, we will make this entire amount as profit (minus commissions). Below 55, we begin to experience less profit until we pass the breakeven point (the dashed horizontal line). But maximum losses are limited here because we have a long put option (with a strike price of 50). The profit/loss function thus turns flat at this lower strike price (the kink at the left-bottom corner of Exhibit 2), indicating that losses cannot get any larger if coffee were to continue to decline.
With both bull put spreads, as well as bear call spreads (see Exhibit 3 below), losses are always limited to the size of the spread (the distance between the strikes) minus the initial net credit received. In our coffee bull put spread, maximum loss is calculated by taking the value of the spread (55 - 50 = $0.05 cents x $375 = $1,875) and subtracting the premium received ($0.029 received for the 55 call minus $0.012 paid for the 50 call, or a net of $0.017 cents x $375 = $638). This gives us a maximum loss potential of $1,237 ($1,875 - $638 = $1,237).
Take a look at Exhibit 3, which contains a bear call spread. As indicated in Exhibit 1 above, bear call spreads profit if the underlying is neutral, bearish or moderately bullish. Just like with the bull put spread, the bear call spread profits even without movement of the underlying, which is what makes these trades attractive, despite their limited profit profile. Since the net credit generated with a credit spread represents time value, the spread will reduce to zero at expiration if the underlying has remained stationary or has not crossed beyond the short strike in the position.
Exhibit 3: Coffee Bear Call Spread
Created using OptionVue5 Options Analysis Software. This example excludes commissions and fees, which can vary from broker to broker.
In our coffee bear call spread (Exhibit 3), we sold the lower 65 call strike and bought the higher 70 call strike for a net credit of ($637.5). Again, each penny is worth $375. The lower strike sold for $937.5 ($0.025 x $375) and the upper strike was bought for $300 ($0.8 x $375). In Exhibit 3, the profit/loss function looks like a mirror image of the bull put spread. As long as July coffee trades at or below the 65 strike, maximum profit is achieved with our bear call spread. If it trades at the 70 strike or higher, maximum loss is reached. Maximum profits are limited to the net credit received when the position was established (minus commissions). And the distance between the two strikes minus the premium received sets maximum losses. Note that the maximum losses are reached as the underlying rises, not falls. Recall that the bull put spread reaches maximum losses as the underlying falls.
The Bottom Line
Bull and bear credit spreads offer a trader a limited-risk strategy with limited profit potential. The key advantage to credit spreads is that in order to win they don't require strong directional movement of the underlying. This is because the trade profits from time-value decay. Vertical credit spreads can thus profit if the underlying remains in a trading range (stationary), freeing the trader from problems associated with market timing and prediction of the direction of the underlying.