Construction: Buy one put, sell one put at a lower strike with the same expiration date (debit spread). The strategy can also be constructed using calls: Buy one call, sell one call at a lower strike with the same expiration date (credit spread). The strategy provides limited gains and limited losses. The Vertical Bear Spread is the same concept as the bull spread, just in the opposite direction.
Function: Low cost stock directional play which allows you two choices to put on the same trade: Long Vertical Put Spread or Short Vertical Call Spread.
When to Use: Use when you feel the stock is likely to fall but not too quickly nor explosively as this strategy has limited profits. Also, when constructed properly, this spread can be used as a premium collection strategy, which will appreciate with the passage of time.
Breakeven: If using put options (debit spread), the breakeven point equals the long put strike minus the debit. If using call options, the breakeven equals the short call strike plus the credit.
Max Gain: Gains are made for all stock prices below the breakeven at expiration. For put options (debit spread), the maximum gain is the difference in strikes minus the debit. For call options (credit spread), the maximum gain is the credit received from selling the spread. Whether using calls or puts, the maximum gain is realized if the stock reaches the short strike or lower.
Max Loss: Losses are incurred for all stock prices above the breakeven point at expiration. For put options, the maximum loss is the amount paid for the spread (the debit). For call options (credit spread), the maximum loss is the difference in strikes minus the credit. Key Concepts – the maximum value of any vertical spread will be equal to the difference between the two strikes. Therefore, both the buyer and the seller will have limited profits and losses. Depending on which strikes you use, time decay can help or hurt the position. Thus, some vertical spreads can make money over time even if stock stays stagnant.
Calls – Buy one January $55 call and sell one January $50 call for a net credit of $3. The breakeven point is $53. If the stock rises above $53 at expiration, you’ll incur losses with the maximum loss being $2. The maximum loss occurs for all stock prices above the $55 strike. For all stock prices below $53, you’ll make money but only down to the $50 strike. The maximum gain is the $3 credit and occurs for all stock prices below the $50 call. As with Vertical Bull Spreads, notice that the max gains, max losses, and breakeven points are identical whether using calls or puts. That will always be true unless a skew is present.
Puts – Buy one January $55 put and sell one January $50 put for a net debit of $2. The breakeven point is $53. For all stock prices above $53 at expiration, you’ll have losses. The maximum loss is the $2 paid for the spread and occurs for all stock prices above $55. If the stock falls below $53 at expiration, you’ll make money, but only down to the $50 strike. The maximum gain is $3, which occurs for all stock prices below the $50 put.