Published orginally at Investopedia.com

By John Summa, CTA, PhD, Founder of OptionsNerd.com

Now that you have a basic idea of what an option spread looks and feels like (of course limited to our simple vertical bull call spread), let’s expand on this foundation to other types of spreads and take a look at another example of a vertical spread. For this example, we will make time a friend to the spreader.

The example from the previous chapter used IBM call strikes of October 85 and 90 to illustrate a simple vertical call debit spread. Recall that vertical means using the same month for constructing the spread. If we were to reverse this type of spread, we would invert the profit/loss dynamics, and it would lead to a credit in your trading account upon opening the position. The objective of the credit spreader – and the parameters of the potential profitability of a credit spread – is fundamentally different despite the mirror image seen in the spread design (i.e. selling instead of buying the OTM and buying instead of selling the FOTM IBM call option).

Because the options used to construct the vertical spread expire at the same time, there is no need to be concerned with rates of time value decay across different months (such as in calendar, or time spreads, which are covered in the horizontal and diagonal spreads section that follows). To visualize the profit/loss dynamics of a vertical call credit spread, let’s return to the example of a vertical call spread with IBM options, where we bought the October 85 and sold the October 90, but this time for a hypothetical debit of \$120. Now we will reverse this order and generate a credit spread in the process. As seen in Figure 1, the lower right-hand side of the profit/loss plot shows the maximum loss of \$380and upper left-hand side shows the maximum profit potential of \$120.

The maximum loss of \$380 results from the short October 85 call expiring in the money but having losses limited by the long side in the trade, the October 90 call.

Here we have taken in a net credit and will profit if the underlying stock closes below 86.20 (85 + 1.20 = 86.20) at expiration, which means we would want to have a neutral-to-bearish outlook on the stock when using this type of spread. The breakeven is determined by adding the premium of the spread (1.20) to the strike price (85). In other words, for a loss to occur, the stock has to trade up to the short strike in the bear call spread and exceed the credit collected (1.20).

For example, if IBM closes at 87 on expiration-day – the third Friday of October – the short option will be in the money and settle at 2.00 (87 – 85 = 2.00). Meanwhile, the October 90 strike will have expired out of the money and will be worthless. The credit spreader will be debited 2.00 (the amount the October 87 is in the money) at settlement, which will be offset only partially by the amount of premium collected when the spread was opened (1.20), for a net loss of -.80, or -\$80. For each spread, there would be a loss of \$80 in this scenario.

Whether using a vertical debit or credit spread, the same principles are at work on the put side. You could use a put debit spread (known as a bear put spread) to trade a bearish outlook (buying an ATM put and selling an FOTM put). On the other hand, if you had a bullish or neutral outlook, you could construct a put credit spread (known as a bull put spread), which involves selling an ATM put and buying an FOTM put to limit potential losses. The profit/loss profile is identical to the vertical call spreads outlined above.
Next:

Go to Part 6 –