There are mainly four type of vertical spread strategies: the bull call spread, the bull put spread, the bear call spread, and the bear put spread. Each of these has you buy one option and sell one option.
Credit or Debit | Long leg | Short leg | |
|---|---|---|---|
Bull put | Credit | Put at lower | Put at higher strike |
Bull call | Debit | Call at lower | Call at higher strike |
Bear put | Debit | Put at higher strike | Put at lower strike |
Bear call | Credit | Call at higher strike | Call at lower strike |
EXIT STRATEGY
When you exit a spread, both legs are usually squared off, rather than exercised, since buying and selling the underlying stock means committing large amounts of capital to the strategy. Instead, you might close out the spread, by making an offsetting purchase of the option you wrote, and an offsetting sale of the option you had
originally purchased.
For example, if you were moderately bullish on stock ABC, which is trading at Rs.55, you might open a bull call spread. You could buy a 60 call for Rs.350 and write a 65 call, receiving Rs.150. Your net debt is Rs.200, which is also your maximum loss if the stock price stays below Rs.60.
If the options stay out-of-the-money
Rs.350 Purchase of 60 call
– Rs.150 Receive on 65 call
= Rs.200 net debit
If the price of the stock rises to Rs.66 at expiration, both options will be in the money, and it’s reasonable to assume the option you wrote will be exercised. If that’s the case, you can exercise your long call and purchase 100 ABC shares for Rs.6,000, and then sell those shares for Rs.6,500 to meet your short 65 call assignment. If exercise and assignment occurred at expiration, your firm would probably net the difference.
You’d earn Rs.500, and after subtracting the debit of Rs.200, your profit would be Rs.300. You would have invested Rs.200 for that Rs.300 profit. Alternatively, at or near expiration, you could close out your short call by buying it back for about Rs.100 and selling your long call for about Rs.600, leaving you with a profit of about Rs.300, after the initial Rs.200 debit.
If the options are in-the-money
Rs.6,500 Sell shares
– Rs.6,000 Purchase shares
= Rs. 500 Proceeds
– Rs. 200 Debit
= Rs. 300 Profit
You committed only Rs.300 in cash (the debit plus the cost of offsetting your short call), instead of the Rs.6,000 necessary if you were to exercise your long call. Either way, you have given up the opportunity to profit if the stock continues to rise.
OFFSET YOUR LOSSES
Offsetting your spread position, or buying back the spread you sold, can be advantageous if the underlying stock has moved against you. If you are bearish on ABC when it is trading at Rs.55, you might open a bear call spread. You can purchase a 65 call for Rs.150, and sell a 60 call, receiving Rs.350. Your net credit is Rs.200, which is also the amount of your maximum profit if ABC stays below Rs.60 and both options expire out-of-the-money.
If the options expire out-of-the-money
Rs.350 Receive on 60 call – Rs.150 Purchase of 65 call
= Rs.200 Net credit
If your expectations were wrong and the stock price rises to Rs.66, both ABC options will be in the money. At or near expiration, you might sell your 65 call for Rs.100, and buy back the 60 call for Rs.600. The loss of Rs.500 would be partially offset by the original Rs.200 credit. If the stock is Rs.66 at expiration, you can assume your short call will be assigned, obligating you to sell 100 ABC shares at Rs.6,000. You’d exercise your long call, and buy 100 ABC shares for Rs.6,500. Your firm would probably net the difference, creating a Rs.500 loss in your account that would be partially offset by your original Rs.200 credit.
If the options are in-the-money
Rs.600 Buy back 60 call – Rs.100 Sell 65 call
= Rs.500 Loss – Rs.200 Credit
= Rs.300 Net loss
EARNING INCOME
Spreads can also be used to create income from stocks you hold. For example, say you bought 100 ABC shares at Rs.50. Now the stock is trading at Rs.30, and you don’t think it will rise much in the near future. You’d like to receive income on your shares, but you don’t want to have them called away from you, incurring a loss for the tax year. You write a slightly out-of-the-money call at Rs.32.50, receiving Rs.250. You simultaneously buy a 35 call for Rs.150. Your net credit is Rs.100.
If the options stay out-of-the-money
Rs.250 Receive on 32.50 call – Rs.150 Purchase of 35 call
= Rs.100 Net credit
If the price of the stock stays below Rs.32.50, you pocket the Rs.100. If the stock price increases above Rs.35, you can close out both options positions at a loss of Rs.250 (the amount of the spread times the number of shares covered), which is reduced to Rs.150 after accounting for your credit. This loss is one you may be willing to accept as your shares of ABC gain value.
If the options are in-the-money
100 Number of shares x Rs. 2.50 Amount of the spread
= Rs. 250 Loss – Rs. 100 Credit
= Rs. 150 Net loss