Vertical Spread

A vertical spread is the buying and selling of two different strikes simultaneously in the same expiration month. There are four types of spreads that will be mentioned with varying frequency. The spreads are a bull call spread, bull put spread, bear call spread and a bear put spread. To summarize, each strategy requires a stock to either exceed or not exceed a certain strike price. Each strategy can be broken down as a debit spread or a credit spread. When you buy (debit) a vertical, you are anticipating that a stock price will exceed a certain strike price. Whey you sell (credit) a vertical, you are anticipating that a stock will NOT exceed a certain strike price.

The difference between buying a spread (debit) vs selling a spread (credit) may seem confusing at first. If you are buying a spread, you DO want the price to exceed beyond a certain strike. If you are selling a spread, you DON’T want the price to exceed beyond a certain strike. It must or must not exceed the option strike being sold in the strategy. Lets look at an example. This is Limited Brands ($LB) the last trading price (9/4/14) is at 64.62. Lets look at each spread to see how they would be set up.

The Debit Vertical Spread

Bull call spread –  This is buying a higher price call strike and selling a lower price call strike. This spread results in a debit. This strategy is used if a stock price is determined to be going up.

Bear put spreadThis is buying a higher price put strike and selling a lower price put strike. This spread results in a debit. This strategy is used if a stock price is determined to be going down.

You determined that LB stock is going up. A bull call spread is buying a higher price call strike and selling lower price call strike in the same expiration month. You chose the spread 62.5/65 because you determined that the price will exceed the option strike being sold (65).

You determined that LB stock is going down or will not move much. A bear put spread is buying a higher price put strike and selling a lower price put strike in the same expiration month. You chose the spread 62.5/65 because you determined that the price will NOT exceed the option strike being sold (62.5).

The Credit Vertical Spread

Bear call spread –  It is selling a higher price call strike and buying a lower price call strike. This spread results in a credit. This strategy is used if a stock price is determined to be going down or not move much.

Bull put spread – It is selling a higher price put strike and buying a lower price put strike. This spread results in a credit. This strategy is used if a stock price is determined to be going up or not move much.

You determined the stock is going down or will not move much. A bear call spread is selling a higher price strike call strike and buying a lower price call strike in the same expiration month. You chose the spread 62.5/65 because you determined that the price will NOT exceed the option strike being sold (62.5).

You determined the stock is going up or will not move much. A bull put spread is selling a higher price put strike and buying a lower price put strike in the same expiration month. You chose the spread 65/62.5 because you determined that the price will NOT exceed the option strike being sold (65).

 

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