A vertical bull spread is an income-generating options strategy suitable for when investors are bullish and expect underlying shares to rise substantially in the near term. A vertical bull spread typically involves a long-short paired trade, using either puts or calls, at out-of-the-money strike prices with the same expiry date.
Example Using Put Options
For example, investors could use two out-of-the-money Put options to capitalize on an anticipated rise in shares by a) buying a Put option at Strike Price I that is well below the current share price, b) selling a Put option at Strike Price II that is higher than Strike Price I but still below the current share price, c) where both Put options have the same expiry date. (An out-of-the-money Put is one where the strike price is below the current share price and investors will not exercise the Put, preferring to sell shares at higher open-market prices instead.)
So, Strike Price I < Strike Price II < Current Share Price and both Puts have identical expiry dates.
Let’s use the ever popular Apple (AAPL) as an example. AAPL shares are currently down 33% from a high of over $700 to about $470. At this point, let’s assume investors believe the selling’s been overdone and are bullish on AAPL… and want to potentially generate some income should AAPL rise.
In such a scenario, investors could:
A) Buy AAPL Puts at $430 strike at a cost of $13.60
B) Sell AAPL Puts at $450 strike and receive $20.95
… for a net gain of $7.35.
The table below shows net proceeds, $735 per contract (where every contract covers 100 shares).
The following table shows income gains and losses under various up and down scenarios for AAPL stock.
For example, if AAPL shares fall to $390, you exercise the long $430 Put and receive $40 per share ($4,000 for a contract of 100 shares) but lose $60 ($6,000 per contract) on the short $450 put, and suffer a loss of $2,000 on Puts, which is partly offset by the $735 of income received when you set up the trade, for a maximum net loss of $1,265. If shares hold at $450, your long $430 Put expires worthless as does your short $450 Put and you are left with a profit of $735 – the maximum profit under this scenario. The trade breaks even at $442.65.
Gains and losses can be more easily visualized on the graph below.
So, if your expectations for the stock come true, you can earn income with this combination trade. However, your maximum loss is always higher than your maximum gain.
Next Time: Vertical Bull Spread Using Call Options & Combining Vertical Put and Call Spreads for Income