Vertical Spreads: Bull and Bear Structures

Vertical spreads combine a long option with a short option at different strikes but the same expiration. They offer defined risk, reduced cost compared to single options, and clear profit targets. Bull spreads profit from rising prices; bear spreads profit from falling prices.

Definition and Key Concepts

Vertical Spread Basics

A vertical spread uses options at the same expiration with different strike prices, creating a position where:

• Maximum gain is capped
• Maximum loss is limited
• Risk and reward are defined at entry

The Four Vertical Spread Types

Debit vs. Credit Spreads

Debit spreads: You pay premium upfront and profit if the position moves in your favor. Credit spreads: You collect premium upfront and profit if the underlying stays away from your short strike.

Both debit and credit versions can express the same directional view—the choice depends on where you want to position strikes relative to the current price.

How It Works in Practice

Bull Call Spread Construction

Example: XYZ trades at $50. You're moderately bullish.

Trade:

• Buy 1 XYZ $50 call at $3.00
• Sell 1 XYZ $55 call at $1.25
• Net debit: $1.75 ($175 per contract)

Greeks Profile:

Payoff Analysis:

Maximum gain: ($55 - $50 - $1.75) × 100 = $325 Maximum loss: $1.75 × 100 = $175 Breakeven: $50 + $1.75 = $51.75 Risk/reward ratio: $175 / $325 = 0.54

Bear Put Spread Construction

Example: ABC trades at $75. You're moderately bearish.

Trade:

• Buy 1 ABC $75 put at $4.00
• Sell 1 ABC $70 put at $1.75
• Net debit: $2.25 ($225 per contract)

Greeks Profile:

Payoff Analysis:

Maximum gain: ($75 - $70 - $2.25) × 100 = $275 Maximum loss: $2.25 × 100 = $225 Breakeven: $75 - $2.25 = $72.75

Credit Spread Example

Bull Put Spread (Credit):

• Sell 1 XYZ $48 put at $2.00
• Buy 1 XYZ $45 put at $0.75
• Net credit: $1.25 ($125 per contract)

This profits if XYZ stays above $48 at expiration.

Maximum gain: $1.25 × 100 = $125 (keep the credit) Maximum loss: ($48 - $45 - $1.25) × 100 = $175 Breakeven: $48 - $1.25 = $46.75

Worked Example

Case Study: Earnings Trade with Bull Call Spread

DEF reports earnings next week. It trades at $100. You expect a beat but want defined risk.

Trade:

• Buy 1 DEF $100 call at $5.00
• Sell 1 DEF $110 call at $2.00
• Net debit: $3.00 ($300 per contract)
• Days to expiration: 7

Position Metrics:

Scenario Analysis:

Comparison to Long Call Only:

The spread costs less and has similar risk/reward, but caps gains if DEF rallies past $110.

Risks, Limitations, and Tradeoffs

Limited Profit Potential

Vertical spreads cap your upside. If the underlying makes a very large move in your favor, you only profit up to the spread width. A single long option would capture more of an outsized move.

Transaction Costs

Two-leg trades incur double commissions compared to single options. Ensure potential profit exceeds transaction costs.

Assignment Risk

Short options in spreads can be assigned early. For American-style options:

• Short calls may be assigned before ex-dividend dates
• Deep ITM short options may be assigned anytime

If assigned, you may need to exercise your long option or take a stock position temporarily.

Time Decay Dynamics

Debit spreads experience net time decay when far from expiration. As expiration approaches:

• ATM spreads see reduced decay
• OTM spreads continue losing value
• ITM spreads hold value well

Common Pitfalls

1. Choosing strikes too wide: Wide spreads cost more and require larger moves to profit.

2. Choosing strikes too narrow: Narrow spreads have limited profit potential relative to costs.

3. Ignoring liquidity at both strikes: Both legs need adequate volume and tight spreads.

4. Holding through expiration with pin risk: If the stock settles between strikes, outcomes can be uncertain.

5. Not considering early assignment: Plan for what happens if your short leg is assigned.

Checklist for Vertical Spread Trading

• Define directional view and magnitude of expected move
• Select strike widths that match profit expectations and risk tolerance
• Calculate maximum gain, maximum loss, and breakeven before entry
• Verify liquidity at both strike prices
• Assess net delta to confirm directional exposure
• Check net theta to understand time decay impact
• Review upcoming events (earnings, dividends) for assignment risk
• Set exit criteria: profit target, stop loss, or time-based

Next Steps

For spreads that use different expirations, see Horizontal and Diagonal Spread Construction. Calendar and diagonal spreads offer additional flexibility in managing time decay and directional exposure.

For hedging strategies that protect stock positions, review Protective Puts and Collars.