Are you interested in diving into options but don’t know where to start? Or maybe you are already kind of familiar with options, and you’re looking to start getting into plays beyond just buying calls and puts.

Vertical spreads are a great place to start if you want to learn more about specific strategies. If you already understand the basics such as what a call and a put is, how they work, and some of the common mistakes when trading options, then vertical spreads could be a great next stepping stone.

If you have an understanding of vertical spreads, that information will serve as a bounce pad to get into even more exotic types of plays such as iron condors and butterfly spreads.

We’re going to give you a complete guide and reference to what vertical spreads are, how they work, and how to use them so that you can equip this powerful tool to your options toolbelt.

Sounds good? Let’s jump in!

What you’ll learn

A vertical spread is an options play that involves simultaneously buying and selling calls, or puts (the two must be the same type of contract) that have the same expiration date, but different strike prices. Your opening trade to begin the play can either be buying or selling the option; it doesn’t really matter. And while this is two different trades, we tend to think of this move as one trade, called a vertical spread.

What makes it a “vertical” spread then, and not horizontal or diagonal? To visualize why this play, or strategy is “vertical”, imagine expiration dates are on the x-axis of a graph, and strike price is on the y-axis. The reason it is a “vertical” spread is because, on the graph, if you plotted two points with the same expiration date but different strike prices and connected a line between the two, it would be vertical.

A vertical spread gets its “vertical” name due to its correlation with strike price.

This same concept applies to the horizontal, or calendar spread. Yet it is only with a horizontal spread that the strike prices remain the same, but there are two different expiration dates, creating a horizontal line.

## How a Vertical Spread Works

Vertical spreads generally work in two different ways. You are buying and selling contracts that have two different values. This means that after you perform the play, you either end up with a net credit (or money coming into your account) or a net debit (money going out of your account).

The way you receive a credit is by selling a contract that is more valuable than the one you bought. And the way you receive debit is the opposite, you buy a contract that is worth more than the one you sell.

The reason why it is advantageous to do what’s called a debit spread, is that the contract you sell reduces the cost you spend on the contract you long, because you receive a premium for selling it. So you end up spending less on the contract you long. Yet this is just one of the options trading secrets with vertical spreads.

If this is a little heavy so far, we understand. We’ll break down each aspect of vertical spreads and give some real world examples to help solidify the information. For now, just know that with vertical spreads, you are either going to end up with a net debit or net credit when you initially place the trades.

## Diving into the Different Types of Vertical Spreads

Spreads are a common play in options that come in all shapes and sizes. For now we’re just focusing on the types of vertical spreads. There are both bullish and bearish vertical spreads, and two strategies within each of those, totaling four plays within the sphere of vertical spreads. We explain in more detail below.

A good way to remember this is, if you’re bullish in the market, you buy low, sell high! As the common saying goes. So with bullish spreads, again, buy the contract with the lower strike price, and sell the contract with the higher strike price. And vice versa for bearish spreads, buy the contract with the higher strike price, sell the contract with the lower strike price.

Now let’s get into the four types of vertical spreads. You’ll notice below that we put “debit” or “credit” in parentheses next to the name of each strategy/ play. Credits and debits are how bullish and bearish spreads encompass four plays. Namely, there is a credit & debit bull spread, and a credit & debit bear spread.

Accounting 101 refresher: debit is money coming in, credit is money coming out.

Here is why this results in a net debit: Remember with bullish vertical spreads, you buy low, sell high. So we’re going to buy a call with a strike price higher than the current underlying price, and sell a call with a strike price lower than the underlying.

ITM calls are worth more than OTM calls. This is a basic concept of option pricing. With a call, if the strike price is lower than the current underlying price, it is ITM. This contract is more valuable because it allows you to buy 100 shares of the underlying stock below its current market value. And with the OTM call, it is worth less, because of course you don’t want to buy the shares for more than the current underlying price.

So say you bought an ITM contract for \$3.50, and sold an OTM contract for \$2.00, so you subtract the premium received from selling the contract with the amount spent buying, or longing the more expensive contract.

(\$3.50 – \$2.00) * 100 = \$150. So the result is that you spent more than you earned, resulting in a debit (money went out instead of coming in).

Now bear credit spreads work differently because you do the inverse when buying and selling the contracts. If you buy low, sell high with bullish spreads, with bearish spreads you sell low, buy high. You sell a contract with a lower strike price than the current underlying price, and buy a contract with a higher strike price than the underlying.

This results in a net credit, or money coming into your account. This is because the call you sold is ITM, therefore more valuable than the other one. So the premium received from selling the contract that is ITM is more than the premium paid for the OTM contract.

So with credit spreads, your max profit is equal to the difference in premium received from buying and selling the two calls. We’ll discuss max profit, loss, and break even points here shortly.

Now with this play, it might be confusing at first why this results in a net credit, when the other bull play resulted in a net debit. This is due to the type of option at play, where in this play we are using puts and not calls.

Remember that a put is ITM when the strike price is above the underlying price because it is more advantageous to sell at a higher price. Same concept applies to OTM puts.

And remember, with bullish vertical spreads we buy low, sell high. Buy the contract with a strike price higher than the underlying (which would make the put ITM), and sell the contract with a lower strike price than the underlying. This means you gained more than you lost, resulting in a net credit.

Lastly, we have the bear put spread. This is the inverse of the play above. As a quick review: you are selling high and buying low, so you sell a put contract that is ITM, and buy a contract that is OTM, resulting in a net debit.

While we’ve briefly reviewed here why these different spreads result in either credits or debits, we’ll get into more detail about credit and debits are what the key differences are later.

## Calculating Profit and Loss on a Vertical Spread

When you calculate profit and loss with options, one of the key factors at play is if you exercised the contract or not. The majority of the time options traders choose to just flip contracts and not exercise the right to buy or sell at a set price.

As we touched on before, it’s a good idea to make sure that you have enough money in your account to cover yourself in the case that you get assigned the contract you sold. This happens when the contract expires out of the money. So if you don’t want the shares assigned, make sure you sell it well before expiration!

With that, let’s get into max profit and loss, as well as the break even with the different vertical spread types.

Max profit = the spread between the strike prices – net premium paid.
Max loss = net premium paid.
Break even point = long call’s strike price + net premium paid.

The “spread” between strike prices is referring to the difference between the two. For example, if you have one contract that’s \$55 and another that’s \$50, the difference is \$5. Next it says net premium paid, in this case it’s a debit. Say you bought a contract for \$3.25, and sold one for \$2.00, the net premium paid is \$1.25. If you calculate the profit you earned, it’d look like this:

[(\$55 – \$50) – (\$3.25 – \$2.00)] * 100 = net profit/ loss
(\$5 – \$1.25) * 100 = \$375 net profit

Break even point = short call’s strike price + net premium received.

Break even point = short put’s strike price – net premium received.

Max profit = the spread between the strike prices – net premium paid.
Max loss = net premium paid.
Break even point = long put’s strike price – net premium paid

We’ll give two examples of vertical spreads, one bullish play and one bearish play.

For the first example, say you’re bullish on Delta Airlines (DAL). The current share price is \$37.00 as of Friday, March 18, 2022. So remember with vertical spreads you want to simultaneously buy and sell two calls or two puts with the same expiration date but different strike prices. In this example we will use two calls, so the play would look something like this:

1. Buy one, in-the-money (ITM) call with a \$34.00 strike price, and an expiration date 1 month out (Apr 18). The premium is \$5.00.
2. Sell one, out-of-the-money (OTM) call with a \$40.00 strike price, with the same expiration as the call we purchased. The premium for this contract is \$4.00.

Now, at expiration, DAL is trading at \$38.00. What you would want to do now is exercise the call you purchased so you can buy DAL for \$34.00 a share and sell it back for its price at the time of expiration. Now let’s calculate your profit:

1. You exercised your call, and purchased 100 shares of DAL for \$34.00 = \$3,400, and you sold those 100 shares back for the underlying price at expiration, which was \$38.00, \$3,800, for a profit of \$400.
2. You also sold an OTM call with a \$4.00 premium, so you earned \$400 from that transaction.
3. Lastly, you spent \$500 on your ITM call.

The net profit from all of these trades = \$400 + \$400 – \$500 = \$300, or \$3.00 per share.

Now let’s look at an example of a bearish vertical spread. With bearish vertical spreads, both with calls and puts, you sell the option with the lower strike price, and buy the option with a higher strike price.

We’ll use SoFi Tech., or SOFI. On March 18, 2022, the price was \$10.00 (it was slightly lower but we’ll use a more even number so the information is easier to follow). And in this example, we’ll use puts instead of calls to change it up a bit. Remember that a vertical spread involves either two calls or two puts, and not one call and one put.

1. Buy one, ITM put with a \$12.00 strike price, with an expiration 3 weeks out (Apr 8). The premium is \$4.00.
2. Sell one, OTM put with a \$8.00 strike price, same expiration. The premium is \$3.00, so you receive \$300.00 in premium from selling the contract.

At expiration, SOFI is trading at \$9.00. You can do the same thing as you did above, and exercise the contract. So in this case that allows you to sell SOFI at \$12.00 per share, for a total of \$1,200.00.

1. When you exercise a put, you can short 100 shares, in this example you short 100 shares at \$12.00 = \$1,200. To profit from this, you can buy the shares back at the current share price of \$9.00. (\$9.00 * 100 = \$900 spent).
a. So \$1,200 from shorting the shares after exercising the contract, and (-\$900) from buying them back = \$300.00 profit.
2. Next, you purchased an ITM put contract for \$4.00 premium per share = \$400 spent.
3. Lastly, you sold a put option at \$3.00 premium per share, for a total profit of \$300

\$300 + \$300 – \$400 = \$200 total profit

## The Difference Between Credit and Debit Spreads

Remember accounting 101? Essentially, a credit is money coming into an account, and a debit is money leaving an account.

So with a credit spread, what you want to do is sell a contract with a higher premium, and buy a contract with a lower premium. This results in a net credit from the differences in premium. Your max profit is equal to the difference in premium you received.

Now with a debit spread, you buy a contract with a higher premium, and sell a contract with a lower premium. Why is this advantageous to the investor employing this play? Because the investor gets the contract they want to long at a discount because of the premium they received from selling the contract.

## When to Close Vertical Spreads and How to Manage Them

In the world of options, more often than not the contracts themselves aren’t exercised, they are generally just traded back and forth to profit from the value on the contract itself. This gives the option trader two options when they are looking to close a vertical spread.

It’s important to note that if you don’t want to exercise your contract, you should close your position well before it expires. Be mindful that the options market is less liquid than the stock market, which can make it challenging to execute trades quickly. Additionally, if you’re trading an option with low volume, it can be difficult to replicate alerts received for stock trades. This can make it tough to sell a contract at the desired price and time. In some cases, it may not be possible to sell a contract within a trading day, which means you might need to try again when the market reopens. Therefore, it’s crucial to plan and be cautious.

Set a price you’re happy selling at, and place a limit order well before expiration.

Another word of caution is, make sure you have enough money in your account to cover 100 shares of the underlying stock in case the option you sold is assigned. If the contract you long expires OTM, it will just expire worthless and you’ll only lose the money you initially spent on it. However, with the contract you sold, you risk being assigned the shares. This happens when the contract expires OTM. Even if you’re planning to close that position before expiration, it’s a good idea to have capital to cover the shares as a worst case scenario.

One final note: if you’re just getting started with these more advanced plays, we recommend just sticking with trading the contracts themselves versus exercising them unless you absolutely have to. This is simply because it is a little easier to manage, there aren’t as many moving parts, meaning less to juggle.

## Wrap Up

Vertical spreads are a very versatile play that can be used if you’re bullish, bearish, or even a little unsure of the movement in the underlying. Understanding vertical spreads will help bridge the gap to understanding their close relatives: diagonal spreads and horizontal (calendar) spreads. Knowledge of vertical spreads also serves as a strong foundation to build on when/ if you want to get into more advanced plays as well. Plays like iron condors and butterfly call spreads have spreads built into them, and are their main components.

Start with some basic vertical spreads first, make sure you have capital to cover you in a worst case scenario, and don’t forget that there’s no such thing as failing, just learning. If you want to use a vertical spread strategy and it doesn’t work, keep a trade journal and record what happened so that you can apply that to your next trades.

Yes, vertical spreads can be profitable. And not only that, but they can be profitable if the underlying price moves up, down, or sideways. Your profit depends on either keeping premium initially received from the difference in price between a contract you sell and a contract you buy, or from a successful move with an option you long.

Vertical spreads are generally a fairly safe strategy, as you generally don’t lose more than you initially spent on the contract you longed (if performing a debit spread). And with credit spreads your max loss only equals the difference between the spread of the strike prices and the net premium received. But again, just be aware that you can be assigned shares if you don’t close your short position.

#### What is Vertical Debit Spread?

A vertical debit spread is a type of vertical spread where you have a net debit in your account. This means that you spent more than you earned (i.e. you spent more on the contract you longed versus than you earned from the contract you shorted). Within the category of debit spreads, there is a bear put, and a bull call spread. These plays are beneficial if you want to long a contract, as you essentially get it at a discount.

#### Do I Need Margin for Vertical Spread?

The margin for a vertical spread is equal to the max loss of the type of spread. This is just to cover you in the case of a worst case scenario. It is not however necessarily “required”.