Types of Vertical Spreads

A spread by definition, is when you sell one option and you buy another option that is correlated to the one you sold. This way if one loses value, then the other gains value and vice versa. This reduces the volatility and is in many ways much safer than purchasing a put or call alone. The way you make money with spreads is when one side of the spread gains more than the other side loses.

The Debit Spread

There are two types of vertical spreads, a debit spread and a credit spread. With a debit spread you will incur a debit when you place the trade. It involves purchasing an at the money option and selling an out of the money option.

Let's take a look at the exchange traded fund (EFT) on the Nasdaq (QQQQ) as an example:

Let's say that it's the beginning of February and we are Bearish on QQQQ, so we decide to purchase the June At The Money Puts. The ETF is trading at $30.00 so we purchase the $30.00 June Put for $2.80.

We then sell the June $20 Put for .45 giving us a total debit of $2.35 (2.80-.45). So our maximum loss here is what we paid for the spread $2.35. If at the end of options expiration the ETF has fallen to a price of $20.00 or less we would have realized our maximum gain of $7.65 (High strike price-low strike price) - (Debit) or ($30.00-$20.00) -(2.35) =$7.65. So our maximum possible gain is almost 3 times our maximum possible gain here.

Maximum Profit = (Higher Strike- Lower Strike) - net debit

Maximum Loss = Net Debit

Break even for call spreads = lower strike + net premium

Break even for put spreads = higher strike - net premium

The Credit Spread

Within a credit spread there are two types. The bull put spread, which you'll use if you think the markets will go up and the bear call spread, which you'll use if you think the markets will drop. In the case of a bull put spread you sell a put at the money and buy a put two or three strike prices below. So let's say the Nasdaq Stock ETF is selling at $29.00 and it's January. You can sell a February $29.00 Put for $1.60 and buy a February Put for .90 bringing in a total of $70 per contract (.70 x 100) If the stock closes above $29.00 at options expiration in February (3rd Friday of the month)then you will keep the full credit. If it ends at $28.30 ($29.00-.70) you will break even. If it ends at $27.00 or below you will lose $130 per contract ($29.00-$27.00)-.70. Depending on the number of contracts that you use you can easily earn anywhere between 1-10% a month using this method. The beauty of it is that as it gets closer to the expiration date the options will begin to lose value, which is what you want to happen. Because once they go to 0 you don't have to do anything, but keep the money that you've already collected.

Why Trade Spreads?

The simplest reason to trade spreads is that they are less volatile and thus less risky than trading options or stocks. The flip side is that by taking less risk you also reduce the amount of potential reward

If you'd like to find out more about options trading and credit spreads click on the link in the resource box below and sign up for a free 10 part course.