OPTION SPREAD STRATEGIES
Option spreads are common strategies used to minimize risk or bet on various market outcomes using two or more options. In a vertical spread, an individual simultaneously purchases one option and sells another at a higher strike price using both calls or both puts.
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.
Option spreads are common strategies used to minimize risk or bet on various market outcomes using two or more options.
In a vertical spread, an individual simultaneously purchases one option and sells another at a higher strike price using both calls or both puts.
A bull vertical spread profits when the underlying price rises; a bear vertical spread profits when it falls.
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.
Types of Vertical Spreads
Here is how each spread is executed:
A Bull Call Spread is purchasing a call option, and simultaneously selling another call option (on the same underlying asset) with the same expiration date but a higher strike price. Since this is a debit spread, the maximum loss is restricted to the net premium paid for the position, while the maximum profit is equal to the difference in the strike prices of the calls less the net premium paid to put on the position.
A Bear Call Spread is selling a call option, and simultaneously purchasing another call option with the same expiration date but at a higher strike price. Since this is a credit spread, the maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the calls less the net premium received.
A Bull Put Spread is writing a put option, and simultaneously purchasing another put option with the same expiration date but a lower strike price. Since this is a credit spread, the maximum gain is restricted to the net premium received for the position, while the maximum loss is equal to the difference in the strike prices of the puts less the net premium received.
A Bear Put Spread is purchasing a put option, and simultaneously selling another put option with the same expiration date but a lower strike price. Since this is a debit spread, the maximum loss is restricted to the net premium paid for the position, while the maximum profit is equal to the difference in the strike prices of the puts less the net premium paid to put on the position.
An Iron Condor is an options strategy consisting of two puts (one long and one short) and two calls (one long and one short), and four strike prices, all with the same expiration date. The iron condor earns the maximum profit when the underlying asset closes between the middle strike prices at expiration. In other words, the goal is to profit from low volatility in the underlying asset.
The iron condor has a similar payoff as a regular condor spread, but uses both calls and puts instead of only calls or only puts. Both the condor and the iron condor are extensions of the butterfly spread and iron butterfly, respectively.
An iron condor is a delta-neutral options strategy that profits the most when the underlying asset does not move much, although the strategy can be modified with a bullish or bearish bias.
Similar to an iron butterfly, an iron condor is composed of four options of the same expiration: a long put further out of the money (OTM) and a short put closer to the money; and a long call further OTM and a short call closer to the money.
Profit is capped at the premium received while the potential loss is capped at the difference between the bought and sold call strikes and the bought and sold put strikes—less the net premium received.
Understanding the Iron Condor
The iron condor strategy has limited upside and downside risk because the high and low strike options, the wings, protect against significant moves in either direction. Because of this limited risk, its profit potential is also limited.
For this strategy, the trader ideally would like all of the options to expire worthlessly, which is only possible if the underlying asset closes between the middle two strike prices at expiration. There will likely be a fee to close the trade if it is successful. If it is not successful, the loss is still limited.
Which Vertical Spread to Use
Consider using a Bull Call Spread when calls are expensive due to elevated volatility and you expect moderate upside rather than huge gains. This scenario is typically seen in the latter stages of a bull market, when stocks are nearing a peak and gains are harder to achieve. A bull call spread can also be effective for a stock that has great long-term potential but elevated volatility due to a recent plunge.
Consider using a Bear Call Spread when volatility is high and a modest downside is expected. This scenario is typically seen in the final stages of a bear market or correction, when stocks are nearing a trough but volatility is still elevated because pessimism reigns supreme.
Consider using a Bull Put Spread to earn premium income in sideways to marginally higher markets, or to buy stocks at reduced prices when markets are choppy. Buying stocks at reduced prices is possible because the written put may be exercised to buy the stock at the strike price, but because a credit was received, this reduces the cost of buying the shares (compared to if the shares were bought at the strike price directly).
This strategy is especially appropriate to accumulate high-quality stocks at cheap prices when there is a sudden bout of volatility but the underlying trend is still upward. A bull put spread is akin to “buying the dips,” with the added bonus of receiving premium income in the bargain.
Consider using a Bear Put Spread when a moderate to significant downside is expected in a stock or index and volatility is rising. Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid, such as to hedge long positions after a strong bull market.
Factors to Consider
The following factors may assist in coming up with an appropriate options/spread strategy for the current conditions and your outlook.
Bullish or Bearish: Are you positive or negative on the markets? If you are very bullish, then you might be better off considering stand-alone calls (not a spread). But if you are expecting a modest upside, then consider a bull call spread or a bull put spread. Likewise, if you are modestly bearish or want to reduce the cost of hedging your long positions, then the bear call spread or bear put spread may be the answer.
Volatility View: Do you expect volatility to rise or fall? Rising volatility may favor the option buyer, which favors debit spread strategies. Declining volatility improves the odds for the option writer, which favors credit spread strategies.
Risk vs Reward: If your preference is for limited risk with potentially greater reward, this is more an option buyer’s mentality. If you seek limited reward for possibly greater risk, this is more in line with the option writer’s mentality.
Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, then the best strategy would be a bear put spread. Conversely, if you are moderately bullish, think volatility is falling, and are comfortable with the risk-reward payoff of writing options, then you should opt for a bull put spread.
Which Strike Prices to Choose
The table above outlined whether the bought option is above or below the strike price of the written option. Which strike prices are used is dependent on the trader’s outlook.
For example, with a bull call spread, if the price of a stock is likely to stay around $55 until the options expire, then you may buy a call with a strike near 50 and sell a call at the 55 strike. If the stock is unlikely to move much, then selling a 60-strike call makes a bit less sense because the premium received will be lower. Buying a call with a 52 or 53 strike would be cheaper than buying the 50-strike call, but there is less greater downside protection with the lower strike.
There is always a trade-off. Before taking a spread trade, consider what is being given up or gained by choosing different strike prices. Consider the probabilities that the maximum gain will be attained or that the maximum loss will be taken. While it is possible to create trades with high theoretical gains, if the probability of that gain being attained is minuscule, and if the likelihood of losing is high, then a more balanced approach should be considered.
The Bottom Line
Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading. Look at the current market conditions and consider your own analysis. Determine which of the vertical spreads best suits the situation, if any, then consider which strike prices to use before pulling the trigger on a trade.