There are two main types of vertical spreads. There is the
vertical call spread and the vertical put spread. Each spread
allows you to do two things. First, you can buy it, making you
long the vertical spread. Second, you can sell it making you
short the vertical spread. Both can be employed to take
advantage of directional stock plays. When we use the term
directional stock play, we refer to using vertical spreads to
capitalize on anticipated stock movements either up or down.
A bull spread is used when the investor feels that a stock is
most likely to go up. As we recall, bullish means to have a
positive outlook on a stocks future movement. There are two
ways to set up a bull spread. The first is with the use of
calls. In this case, a bullish investor would buy a vertical
call spread (bull call spread). This is accomplished by buying a
call with a lower strike price and selling a call with a higher
strike price.
The second way to construct a bull spread is with the use of
puts. A bullish investor could sell a vertical put spread (bull
put spread) hoping to profit from an increase in the stocks
value. The investor would sell a put with a higher strike price
and buy a put with a lower strike price. Lets take a look at
how the P&L chart of a Bull Spread looks below.
To recap, if you feel a stock will be increasing in value, you
may put on a bull spread by either buying a vertical call spread
(bull call spread) or selling a vertical put spread (bull put
spread)
A bear spread, however, is used when, you the investor, feels a
stock is likely to trade down. Remember, bearish means that
ones outlook on the future movement of the stock is negative.
To take advantage of this expected downward movement, the
investor would put on a bear spread. This can be done in either
of two ways.
First, the investor can do it using puts. The purchase of a
vertical put spread (bear put spread) can be accomplished by
purchasing a put with a higher priced strike and selling a put
with a lower priced strike.
The second way an investor can construct a bear spread is by
using calls, specifically, by selling a vertical call spread
(bear call spread). You do this by selling a call with a lower
strike price and purchasing a call with a higher strike price.
So if you think that a stock is likely to decrease in value, you
sell a vertical call spread (bear call spread) or purchase a
vertical put spread (bear put spread). Lets take a look at the
P&L diagram for a Bear Spread below.
Finally, there are two fundamentals that are universal to all
vertical spreads. These fundamentals are critical to
understanding the foundation of the vertical spread strategy:
(1) you can determine a vertical spreads maximum value by
taking note of the difference between the two strikes and (2)
vertical spreads have intrinsic value. |
