Les options

When to use :

Bull Spread: Used by an investor who may not be entirely comfortable with either a long Call or short Put position. It is a popular bullish trade because it allows the investor to establish a position even when unsure of his or her bullish expectations.

Bear Spread: Used by an investor who thinks XYZ will fall in price but is not sure of magnitude. A popular bearish trade because it may be entered as a conservative position when uncertain about the likelihood of a decline.

Selection: Month & Strike Price.

Bull Spread: The more bullish the investor’s outlook, the farther apart the strike prices. If less bullish, select strike prices that are closer together.

For bull spreads using Calls, the more the long Call is in-the-money, the more conservative the spread. For bull Put spreads, the more ITM the two striking prices, the more aggressive the spread.

The price of any bull spread is directly related to its being ITM or OTM and the amount of time until its expiration.

Bear Spread: The more bearish the investor’s outlook, the farther apart the strike prices. If less bearish, select strike prices that are closer together.

For bear Call spreads, the more the short Call is ITM, the more aggressive the spread. For bear Put spreads, the more OTM the two striking prices, the more aggressive the spread.

The price of a bear spread is directly related to its being ITM or OTM and the amount of time until its expiration.

Profit & Loss Characteristics:

The second option in a vertical spread is generally added because the investor wants to either reduce the cost of a purchased option or cap the loss potential of a written option. The investor is in effect “hedging” his or her opinion.

A long Call (Put) vertical spread is often created because the Call (Put) option that the investor wants to purchase requires too large of an initial debit. As a result, the investor writes a higher strike Call (lower strike Put) in order to reduce the initial capital required.

In creating a long Call (Put) vertical spread, the investor accepts a trade-off:
A bullish (bearish) strategy with a predetermined maximum profit for a lower break-even point (higher break-even point) and a lower initial capital commitment.

Sample calculation:

Strategy #1: Long Call
Long 1 Oct 60 Call @ 5 1/8

Initial Debit: $512.50

Break-even point: $65 1/8
Maximum loss: $512.50
Maximum profit: Unlimited

Strategy #2: Long Call Vertical Spread
Long 1 Oct 60 Call @ 5 1/8
Short 1 Oct 65 Call @ 3 1/8

Initial Debit: $200.00

Break-even point: $62
Maximum loss: $200.00
Maximum profit: $300.00

By doing so, the investor creates a position that has both limited risk and limited reward. It’s simply a trade-off. The investor is accepting less profit potential in order to limit the initial cost/risk inherent in the first option.

P & L Characteristics: Debit vertical spreads –
- Long bull Call spread, or
- Long bear Put spread

The maximum loss is equal to the net debit of the spread and occurs if the long option expires out-of-the-money.

The maximum profit is equal to the difference between the spread’s two strike prices minus the spread’s initial debit. This occurs once the written option becomes in-the-money.

P & L Characteristics: Credit vertical spreads –
- Short bull Call spread, or
- Short bear Put spread

The maximum loss is equal to the difference between the spread’s two strike prices minus the spread’s initial credit. This occurs once the long option becomes in-the-money.

The maximum profit is equal to the spread’s initial credit and occurs if the written option expires out-of-the-money.

Break-even Points:

Vertical Spread (Call):

Lower Strike Price + Spread Price

Vertical Spread (Put):

Higher Strike Price – Spread Price

Time Decay:

Varies. If XYZ is between strike prices, time decay is minimal. If XYZ is near the long option’s strike price (60), losses increase at faster rate as time passes. If XYZ is near written option’s strike price (65), profits increase at faster rate as time passes.

Volatility:

The impact of a change in volatility on Vertical Spreads depends on whether one or both of the options are in-the-money and the amount of time until expiration.

Assignment Risk:

As is the case with all written options, the investor must continuously monitor the spread for possible assignment pf in-the-money options prior to their expiration.