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Which Vertical Option Spread Should You Use?

Understanding the features of the four basic types of vertical spreads—bull call, bear call, bull put, and bear put—is a great way to further your learning about relatively advanced options strategies. Yet to deploy these strategies effectively, you also need to develop an understanding of which option spread to use in a given trading environment or specific stock situation. First, let’s recap the main features of the four basic vertical spreads.

Basic Features of Vertical Spreads
Each vertical spread involves buying and writing puts or calls at different strike prices. Each spread has two legs: One leg is buying an option, and the other leg is writing an option.

This can result in the option position (containing two legs), giving the trader a credit or debit. A debit spread is when putting on the trade costs money. For example, one option costs $300, but the trader receives $100 from the other position. The net premium cost is a $200 debit.

If the situation were reversed—the trader receives $300 for putting on an option trade, and the other option costs $100—then the two option contracts combine for a net premium credit of $200.

Credit and Debit Spreads
Vertical spreads are used for two main reasons:

For debit spreads, to reduce the premium amount payable.
For credit spreads, to lower the option position’s risk.
Let’s evaluate the first point. Option premiums can be quite expensive when overall market volatility is elevated, or when a specific stock’s implied volatility is high. While a vertical spread caps the maximum gain that can be made from an option position, compared to the profit potential of a stand-alone call or put, it also substantially reduces the position’s cost.

Such spreads thus can be easily used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg.

As far as credit spreads are concerned, they can greatly reduce the risk of writing options, since option writers take on significant risk to pocket a relatively small amount of option premium. One disastrous trade can wipe out positive results from many successful option trades. In fact, option writers are occasionally disparagingly referred to as individuals who stoop to collect pennies on the railway track. They happily do so—until a train comes along and runs them over.

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#DebitSpreads #InTheMoney #TradingOptions
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