Spreads: verticals

In short

A friend of mine once said that buying a stock option felt like buying a lottery ticket with a very short fuse. A vertical spread can soften that fuse. It pairs one option you buy with one option you sell, on the same stock, with the same expiration date. If you are curious how the pair caps both cost and possible loss, the answer is that each leg offsets part of the other. The price of that cap on loss is a cap on gain, and the cap is worth knowing before you place any order. Your broker will ask you to get approval for spreads, and the Options Clearing Corporation publishes a booklet called Characteristics and Risks of Standardized Options that is worth reading first. Take your time with it. Nobody is checking your speed.

The whole of it

What it is

I once watched an old farmer haggle over a pair of fence posts. He wanted a good price, but he also knew he could not afford to be wrong. A vertical spread works much like that. It pairs the purchase of one option with the sale of another at a different strike price. The strike price is the fixed price at which the option lets the holder buy or sell the stock. Both options share the same stock and the same expiration date, which is the day the contracts end.

You have probably heard that options come in two kinds. A call gains value when the stock rises. A put gains value when the stock falls. A vertical spread uses two calls or two puts, never one of each. The word vertical simply points to the strike prices, which stack up and down the option chain like rungs on a ladder.

There are four common versions. A bull call spread and a bear put spread are debit spreads, meaning the trader pays money up front. A bull put spread and a bear call spread are credit spreads, meaning the trader collects money up front. Each contract normally covers 100 shares, so every price you see gets multiplied by 100.

How it works

If you are studying how a bull call spread is built, picture it this way. The trader buys a call at a lower strike and sells a call at a higher strike. The call that is sold brings in cash. That cash cuts the cost of the call that is bought. In return, the trader gives up any gain above the higher strike.

Think of it as renting a room instead of buying the house. You pay less, but you only get so much space. The most that can be lost is what was paid. The most that can be gained is the gap between the two strikes, minus what was paid.

Credit spreads run the other way. In a bull put spread, the trader sells a put at a higher strike and buys a put at a lower strike. Cash comes in today. The put that was bought is the safety net. It keeps a bad drop from turning into a deep hole. The most that can be gained is the cash collected. The most that can be lost is the strike gap minus that cash.

Both sides are tied together by the same expiration date. As that day nears, the value of each option shifts. If the trader sold the short option and the stock moves against them, the buyer may exercise it early. Early exercise means the buyer uses the option before expiration. It is rare, but it can happen, and it is one reason to read the risk booklet.

The numbers, and where to find yours

Every spread rests on a few figures. The strike prices come from the option chain your broker shows you. The premium, which is the price of each option, comes from the same screen. The contract size is 100 shares for standard stock options, as the Options Clearing Corporation explains in its booklet.

Costs matter too. Your broker may charge a fee per contract, and a spread has two contracts, so the fee applies twice. Look at your broker's published commission schedule for the exact figure. Some brokers charge nothing for the trade itself but still pass along small regulatory fees. Check yours.

Taxes depend on how long a position is held and on how the trade is built. The Internal Revenue Service explains the rules in Publication 550, Investment Income and Expenses. The tax rate on a gain follows your own situation and the rules for the year, so I will not guess at it here. Where a yearly figure applies, the site will fill it in for you: the current figure, which the official source publishes each year is the long term rate, and the current figure, which the official source publishes each year describes how short term gains are taxed. Spread trades often run for only a few weeks or months, so the short term rule is one many traders meet.

Margin is the last piece. A debit spread needs only the cash paid. A credit spread needs your broker to hold back cash as collateral, which is money set aside to cover the worst case. That amount is the strike gap times 100, minus the credit taken in. Your broker's margin rules set the details.

A worked example

Let me tell you about a woman named Dana. She follows a company whose stock sells for 50 dollars a share. She wonders whether it may rise over the next two months, but she does not want to risk much.

She looks at the option chain. A call with a strike of 50 dollars costs 3.00 dollars. A call with a strike of 55 dollars costs 1.00 dollar. Both expire on the same date.

Dana opens a bull call spread. She buys the 50 dollar call and sells the 55 dollar call. Her net cost per share is 3.00 minus 1.00, which is 2.00 dollars. One contract covers 100 shares, so she pays 2.00 times 100, or 200 dollars. Her broker also charges a fee per contract, but we will set that aside to keep the math clean.

Now look at her limits. The most she can lose is the 200 dollars she paid. The most she can gain starts with the strike gap. The gap is 55 minus 50, which is 5.00 dollars. Subtract her 2.00 dollar cost, and she is left with 3.00 dollars per share. Times 100, that is 300 dollars.

Her break even point is the lower strike plus her cost. That is 50 plus 2.00, or 52 dollars. If the stock ends at 52 dollars at expiration, she gets her money back and nothing more.

Say the stock ends at 56 dollars. Her 50 dollar call is worth 6.00. Her short 55 dollar call is worth 1.00, and she owes that. The net is 6.00 minus 1.00, or 5.00 dollars per share. She paid 2.00, so her gain is 3.00 per share, or 300 dollars. That matches her cap. The stock could climb to 70 dollars and she would still make 300 dollars, no more.

Say instead the stock ends at 48 dollars. Both calls expire worthless. Dana loses the 200 dollars. It stings, but it is the number she picked going in. That is the whole bargain.

Where it goes wrong

I have seen good people stumble here, and it is no mark against their sense. The first trouble is forgetting that the gain is capped. A spread feels safe, so folks sometimes ignore how little room they have on the upside.

The second trouble is the short option. Selling an option means taking on an obligation. If the stock lands between the two strikes near expiration, things can get messy. One leg may be exercised while the other is not. That can leave a trader holding shares or owing shares they did not plan on. Read how your broker handles this before it happens.

The third trouble is cost. Two contracts mean two fees. On a small trade, those fees can eat a big slice of a small gain. Run the math with the fees in, not out.

The fourth trouble is timing. Options lose value as expiration nears, and a spread does not fully escape that. Being right about direction but wrong about timing still costs money.

Last, there is the paperwork. Brokers must approve you for spreads, and they ask about your experience and goals. Answer honestly. The questions are there to protect you.

Questions to answer before you leave this page

Do you know exactly how much you could lose on this trade, in dollars, and can you afford to lose it? Have you read the Options Clearing Corporation booklet called Characteristics and Risks of Standardized Options? Do you know what your broker charges per contract, and have you counted it twice for the two legs? Could you explain, in plain words, what happens if the stock lands between your two strikes on expiration day? Does your broker approve you for spreads, and do you understand the collateral a credit spread needs? Have you checked how the Internal Revenue Service treats your gains in Publication 550, and do you know which tax year rules apply to you?