Understanding the vertical spread option strategy

How to construct a vertical spread

• Determine your market outlook. Are you bullish (expecting prices to rise) or bearish (expecting prices to fall) on the asset?
• Decide between calls or puts. For a bullish view, you can use a bull call spread or a bull put spread. For a bearish view, you can use a bear put spread or a bear call spread.
• Choose strike prices. Bull call spread, buy a call at a lower strike price (closer to the current market price) and sell a call at a higher strike price. Bear Put Spread, buy a put at a higher strike price and sell a put at a lower strike price. Bull put spread, sell a put at a higher strike price and buy a put at a lower strike price. Bear call spread, sell a call at a lower strike price and buy a call at a higher strike price.
• Select an expiration date. Choose an expiration based on your market outlook. Near-term expirations are suitable for short-term moves, offering lower costs. Longer-term expirations provide more time for your market prediction to play out but come at a higher cost.
• Understand the net premium. If the cost of the option you’re buying is higher than the premium you collect from the option you’re selling, this is a debit spread (e.g., bull call spread). If the premium collected from the sold option exceeds the cost of the purchased option, this is a credit spread (e.g., bull put spread).

How does it work in practice?

Example: Bull call spread using crude oil futures

Let’s say WTI crude oil futures are trading at USD 75 per barrel, and you expect prices to rise in the next two months due to seasonal demand. You want to profit from this anticipated upward movement while limiting your costs. A bull call spread offers a balanced way to achieve this.

Trade construction

Underlying futures contract example: Use the WTI crude oil futures contract

1. Select Strike Prices:
2. Buy a call option with a strike price of USD 75 for a premium of USD 3.00.
3. Sell a call option with a strike price of USD 80 for a premium of USD 1.20.
4. Net Debit (cost):
5. The total premium paid is the difference between the cost of the long call and the premium collected from the short call:
6. USD 3.00 (long call) - USD 1.20 (short call) = USD 1.80 per barrel.
7. Since one WTI crude oil futures contract covers 1,000 barrels, the total cost of this spread is USD 1,800.

Profit and loss potential

• Maximum profit: The most you can earn occurs if crude oil prices rise above the higher strike price (USD 80) at expiration. Maximum Profit = (Higher Strike - Lower Strike) - Net Premium Paid. For this trade: (USD 80 - USD 75) - USD 1.80 = USD 3.20 per barrel, or USD 3,200 total.
• Maximum loss: Your loss is limited to the net premium you paid. Maximum Loss = USD 1.80 per barrel, or USD 1,800 total.
• Breakeven price: The breakeven price is the lower strike price plus the net premium paid. Breakeven = USD 75 + USD 1.80 = USD 76.80.

Decision-making: choosing between calls and puts

When deciding which type of vertical spread to use, several factors should guide your decision:

• Directional bias. With a bullish outlook use bull spreads (either a bull call spread or a bull put spread). With a bearish outlook use bear spreads (either a bear put spread or a bear call spread).
• Risk tolerance. Credit spreads (e.g., bull put spreads or bear call spreads) involve selling a more expensive option and buying a less expensive one. They require margin but have a limited risk profile and the goal is to collect and keep the net premium received, which is the maximum profit. Debit spreads (e.g., bull call spreads or bear put spreads) involve buying a more expensive option and selling a cheaper one. They do not require a margin account and limit your upfront cost and the maximum risk is confined to the net premium paid, while the potential reward is capped.
• Volatility expectations. If you expect volatility to increase debit spreads are more favorable because they benefit from rising option prices. However, If you expect volatility to decrease: Credit spreads are ideal as they profit from time decay and premium erosion.
• Strike selection. Near-the-Money strikes cost more but provide a higher probability of profitability. Out-of-the-Money strikes are cheaper but require significant market movement to generate profit.

Conclusion

Vertical spreads can be a powerful tool for traders who want to align their market views with a disciplined risk-management approach. Whether you are bullish or bearish, spreads offer flexibility, affordability, and clear boundaries for gains and losses.

By carefully selecting strike prices, expirations, and the type of spread, you can tailor the strategy to your specific outlook and risk tolerance. Moreover, monitoring the Greeks can help you anticipate how changes in time, price, and volatility will affect your position, allowing for informed adjustments along the way.

For traders seeking a "middle ground" strategy—like booking a holiday that balances luxury with cost—vertical spreads may be an excellent choice.