Vertical spreads are one of my favorite subjects to teach. On the surface, they appear to be rather straightforward but, in fact, they are not. The overly simplistic view of vertical spreads held by many traders can lead to poor trade management and ultimately a heap of losers that should have been winners.

Vertical Spreads
Vertical spreads can be divided into two categories: debit spreads and credit spreads. Debit spreads, of course, are called such because when they are established, the trader’s account is debited; that is, the trader pays for the spread upfront in hopes it will gain in value and can be sold at a higher price later. Credit spreads, on the other hand, are called such because they are done for a credit; the trader receives cash upfront, hoping to buy the spread back later at a cheaper price.

While these two spreads seem to be very different animals, and are often traded as such, debit spreads and credit spreads are really not that different. In fact, they are essentially the same thing. To understand this, let’s look at another option spread called a box.

Understanding Boxes
A box is a four-legged strategy in which a trader buys (or sells) both a debit spread and a credit spread on the same option class, in the same expiration cycle, with the same strike prices. Let’s look at an example.

For this example, a trader will buy the 40-41 box. To complete the box, the trader will:

Buy 1 40 call at 1.12
Sell 1 41 call at 0.60
Sell 1 40 put at 0.86
Buy 1 41 put at 1.34

Notice the first two legs of the spread listed here — buy 1 40 call at 1.12, sell 1 41 call at 0.60 — form a debit call spread. The second pair of legs — sell 1 40 put at 0.86, buy 1 41 put at 1.34 — forms a debit put spread. Both debit spreads.

The call debit spread is purchased for a total of 0.52. Let’s look at the maximum gain and loss of this spread at expiration.

Stock above 41: Max profit 0.48
Stock below 40: Max loss 0.52

The put spread was bought for 0.48. Let’s look at the put debit spread if held until expiration.

Stock above 41: Max loss 0.48
Stock below 40: Max profit 0.52

So if a trader bought both of these spreads for a total of $1 (that’s 0.52 for the call spread plus 0.48 for the put spread — incidentally the distance between the two strikes) and the stock settles above 41 at expiration, the gains on the call spread would be offset by losses on the put spread. Below 40, the losses on the call spread would be offset by gains on the put spread. And, in fact, if the stock ended between the two strikes at expiration, any gains on one of the spreads would be directly offset by comparable losses on the other spread.

(Please note, dividends, interest, the bid-ask spread, exercise style, and hard to borrow issues are all factored into the arbitrage of boxes. Because of this, it is common for boxes to trade at a price other than the distance between the two strikes as shown here with this $1 box.)

Looking at the box another way, the trader is buying synthetic stock at the 40 strike (buying the 40 calls, selling the 40 puts) and selling synthetic stock at the 41 strike (selling the 41 calls and buying the 41 puts) for a total debit of $1. The trader would be paying $1 for an asset that is worth, in arbitrage terms, $1.

While most active individual traders don’t trade boxes, an important lesson for vertical spread trading can be gained from this exercise. It has been illustrated, that buying a call spread is an exactly opposite position from buying a put spread — they offset each other (again, once interest and other influences are factored in). Therefore the logic must follow that buying a call spread must be synthetically the same as selling a put spread. And, indeed, it is.

Consider buying the call spread vs. selling the put spread.

Debit call spread at expiration:

Stock above 41: Max profit 0.48
Stock below 40: Max loss 0.52

Credit put spread at expiration:

Stock above 41: Max profit 0.48
Stock below 40: Max loss 0.52

Likewise, between the two strikes will show an identical arbitrage P&(L) at expiration. To be sure, the P&(L) diagrams of the two strategies — debit call spread and credit put spread — would be identical too for this example.

With this in mind, we can now study the psychology of a vertical spread trader, and how the trader must adapt as the spread moves more in- or out-of-the-money. This will be discussed in the upcoming Part 2 of this series.