Construction: Buy one call, sell one call at a higher strike with the same expiration date. The strategy results in a debit. The strategy can also be constructed using puts: Buy one put, sell one put at a higher strike with the same expiration date. By using puts, the strategy results in a credit. Whether using calls or puts, the strategy provides limited gains and limited losses.
Function: Low cost stock directional play which allows you two choices to put on the same trade: Long Vertical Call Spread or Short Vertical Put Spread.
Bias: Bullish.
When to Use: Use when you feel the stock is likely to rise 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 means it will appreciate with the passage of time.
Breakeven: If using call options, the breakeven point equals the long call strike plus the debit. If using put options, the breakeven equals the short put strike minus the credit.
Max Gain: Gains are made for all stock prices above the breakeven point at expiration. For call options, the maximum gain is the difference in strikes minus the debit. For put options, the maximum gain is the credit received from selling the spread. For both calls and puts, the maximum gain is realized if the stock price reaches the short strike or higher.
Max Loss: Losses are realized for all stock prices below the breakeven at expiration. For call options, the maximum loss is the amount paid for the spread (the debit). For put options, it’s the difference in strikes minus the credit. The maximum gain plus the maximum loss must equal the difference in strikes. The maximum loss is always realized if the stock price reaches the long strike or lower at expiration.
Key Concepts: The strategy has a bullish bias, but with limited gains and limited losses. The maximum value of a Vertical Bull Spread will be equal to the difference between the two strikes. Depending on which strikes you use, time decay can help or hurt the position. The strategy shares the same profit and loss chart as the Collar.
Examples:
Calls – Buy one January $50 call and sell one January $55 call for a net debit of $2. The breakeven point is $52. Your maximum loss is the $2 paid for the spread. If the stock rises above $52, you’ll make money, but only up to the $55 strike. The maximum gain is $3, which occurs for all stock prices above the $55 call.
Puts – Buy one January $50 put and sell one January $55 put for a net credit of $3. The breakeven point is $52. If the stock falls below $52, you’ll incur losses, but the maximum loss is $2 and occurs for all stock prices below the $50 strike. For all stock prices above $52, you’ll make money but only up to the $55 put. The maximum gain is the $3 credit and occurs for all stock prices above the $55 put. Note that both the call and put versions share the same breakevens, max gains, and max losses. That will be true unless a skew is present.