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  1. Option Spreads: Introduction
  2. Option Spreads: Selling And Buying To Form A Spread
  3. Option Spreads: Vertical Spreads
  4. Option Spreads: Debit Spreads Structure
  5. Option Spreads: Credit Spreads Structure
  6. Option Spreads: Horizontal Spreads
  7. Option Spreads: Diagonal Spreads
  8. Option Spreads: Tips And Things To Consider
  9. Options Spreads: Conclusion

Now that you have a basic idea of what an option spread looks like (of course, limited to our simple vertical bull call spread), let's expand to other types of spreads and take a look at another example of a vertical spread. For this example, we’ll make time a friend to the spread trader.

A Vertical Bear Call Credit Spread

The example from the previous chapter used MSFT call strikes of October 85 and 90 to illustrate a simple vertical call debit spread. Recall that vertical means using the same month for constructing the spread. If we were to reverse this type of spread, we would invert the profit/loss dynamics, and it would lead to a credit in your trading account upon opening the position. The goal of the credit spreader, and the parameters of the potential profits for a credit spread, are fundamentally different despite the mirror image seen in the spread design (i.e. selling instead of buying the OTM, and buying instead of selling the FOTM MSFT call option).

Because the options used to construct the vertical spread expire at the same time, there is no need to be concerned with rates of time value decay across different months (such as in calendar spreads). To visualize the profit/loss dynamics of a vertical call credit spread, let's return to the example of a vertical call spread with MSFT options, where we bought the October 85 and sold the October 90, but this time for a hypothetical debit of $120. Now we will reverse this order and generate a credit spread in the process. (For related reading, see Pencil in Profits in Any Market with a Calendar Spread.)

As seen in the figure below, the lower right-hand side of the profit/loss plot shows the maximum loss of $320 and upper left-hand side shows the maximum profit potential of $120. The maximum loss of $320 results from the short October 85 call expiring in the money but having losses limited by the long side in the trade, the October 90 call.

Vertical bear call credit spread.

In this example, we have taken in a net credit and will profit if the underlying stock closes below 86.20 (85 + 1.20 = 86.20) at expiration, which means we would want a neutral-to-bearish outlook on the stock when using this type of spread. The breakeven is determined by adding the premium of the spread (1.20) to the strike price (85). In other words, for a loss to occur, the stock must trade up to the short strike in the bear call spread and exceed the credit collected (1.20).

For example, if MSFT closes at 87 on expiration day, the short option will be in the money and settle at 2.00 (87 – 85 = 2.00). Meanwhile, the October 90 strike will have expired out of the money and be worthless. The trader will be debited 2.00 (the amount the October 87 is in the money) at settlement, which will be offset partially by the amount of premium collected when the spread was opened (1.20), for a net loss of -.80, or -$80. Each spread would be a loss of $80 in this scenario. (See also: How is a Short Call Used in a Bear Call Spread Option Strategy?)

Whether you use a vertical debit or credit spread, the same principles are at work on the put side. You could use a put debit spread (known as a bear put spread) to trade a bearish outlook (buying an ATM put and selling an FOTM put). On the other hand, if you had a bullish or neutral outlook, you could construct a put credit spread (known as a bull put spread), which involves selling an ATM put and buying an FOTM put to limit potential losses. The profit/loss profile is identical to the vertical call spreads outlined above. (For more, see Vertical Bull and Bear Credit Spreads and Bear Put Spreads: A Roaring Alternative to Short Selling.)


Option Spreads: Horizontal Spreads
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