Defining Vertical Spreads

How Vertical Spreads Are Created

Creating a vertical spread is basically very simple. You can create one by buying options contracts, using the buy to open order, and selling contracts, using the sell to open order. The contracts must be of the same type, have the same expiration date and be based on the same underlying security but have different strike prices. They can be either debit spreads which incur an upfront cost, or credit spreads which would give you an upfront credit.

The options contracts involved in creating a vertical spread appear vertically stacked when looking at them on an options chain. If you are not familiar with what options chains are and they work, then please read our article on them, which explains how they are used to display information regarding options contracts and their prices.

Example of a Vertical Spread

An example of a vertical spread would be as follows. You use a buy to open order to buy 100 of the following options contracts:

• Call
• Based on stock in Company X
• Company X stock currently trading at $50
• Expiration Date of August 2013
• Strike Price of $49
• Ask Price of $2

You then use a sell to open order to write 100 of the following contracts:

• Call
• Based on stock in Company X
• Company X stock currently trading at $50
• Expiration Date of August 2013
• Strike Price of $52
• Bid Price of $.70

By buying calls at one strike price, and writing calls on the same underlying security with a different strike price you have created a vertical spread. You could also do the same with puts too. In this example you have created a debit spread, as you have spent more on the options contracts you have bought than you have recouped on the ones you have written.

The example above would be used if you were expecting Company X stock to increase in price, but no higher than $52.00. In the event that Company X stock did move to exactly $52 by August 2013, you would be able to exercise the contracts you bought for a profit. The contracts you had written would expire worthless as the strike price would be equal to the price of the underlying stock, meaning you would also have profited from writing them.

In the event that Company X stock went higher than $52 you would make more profits on the contracts you had bought, but this would be offset by the losses you would incur on the contracts you had sold. Should the price of Company X stock fall, then you would lose the money you had invested in buying contracts, but this would at least be offset by the money you received for writing contracts.

The above example is known as a bull call spread. There are also different types of vertical spreads, as explained below.

Types of Vertical Spreads and Their Uses

Vertical spreads can be either bull vertical spreads or bear vertical spreads; you would use bull verticals when you were expecting the underlying security to increase in price and bear verticals when you were expecting the underlying security to fall in price. There are two further types of each based on whether you are using calls options or puts, for a total of four main types.

A bull call spread, as per the example above, involves buying calls that are usually in the money or at the money and offsetting some of the cost of taking that position by selling calls that are out of the money. A bull put spread involves selling puts that are in the money or at the money and reducing the exposure of taking this position, and the margin required, by buying puts that are out of the money.

A bear call spread involves buying out of the money calls to help reduce the exposure and margin from writing in the money or at the money calls. A bear put involves selling out of the money puts to offset some of the cost from buying in the money or at the money puts.