Debit vertical spreads: bull call and bear put payoffs

1. What you will learn

This lesson introduces the vertical spread, the building block for almost every advanced options strategy in this course. By the end you should be able to:

• define a vertical spread and distinguish a debit spread from a credit spread;
• construct a bull call spread and a bear put spread from two option legs;
• calculate the net debit, maximum profit, maximum loss and breakeven at expiry;
• draw and read an expiry payoff table for a two-leg position;
• explain how the spread changes the position's exposure to direction, time decay and volatility compared with a single long option.

All figures in this lesson are hypothetical teaching numbers. This is exam and professional education, not a recommendation to trade any instrument.

2. The idea explained

A vertical spread is a position made of two options on the same underlying, of the same type (both calls or both puts) and the same expiry, but with different strike prices. It is called "vertical" because, in an old printed option chain, strikes were listed one above another, so the two legs sat vertically on the page.

Debit and credit. If the option you buy costs more than the option you sell, you pay money at the start: this is a debit spread. If the option you sell brings in more than the option you buy, you receive money: this is a credit spread. This lesson covers the two debit spreads; the next lesson covers the two credit spreads.

The bull call spread. You buy a call at a lower strike (K1) and sell a call at a higher strike (K2), same expiry. The lower-strike call is always worth at least as much as the higher-strike call, so you pay a net debit. You profit if the underlying rises, but the short call caps your gain above K2.

At expiry, for underlying price S:

• Long call value = max(S − K1, 0)
• Short call value = −max(S − K2, 0)
• Net profit = max(S − K1, 0) − max(S − K2, 0) − net debit

From this come three standard results:

• Maximum loss = net debit, which occurs when S is at or below K1 (both calls expire worthless).
• Maximum profit = (K2 − K1) − net debit, which occurs when S is at or above K2.
• Breakeven = K1 + net debit.

The distance K2 − K1 is called the width of the spread. The width is the most the spread can ever be worth at expiry, which is why the maximum profit is width minus what you paid.

The bear put spread. You buy a put at a higher strike (K2) and sell a put at a lower strike (K1), same expiry. The higher-strike put is the more valuable one, so you again pay a debit. You profit if the underlying falls, with the gain capped below K1.

• Maximum loss = net debit, when S is at or above K2.
• Maximum profit = (K2 − K1) − net debit, when S is at or below K1.
• Breakeven = K2 − net debit.

Why traders use debit spreads rather than a single option. Selling the second option reduces the cost of the position. That lowers the breakeven and lowers the maximum loss, in exchange for giving up profit beyond the short strike. The spread is a trade-off between cost and potential.

Exposure to the Greeks. A single long call has positive delta (it gains when the price rises), negative theta (it loses value as time passes) and positive vega (it gains when implied volatility rises). In a bull call spread the short call offsets part of each of these. The result is:

• Net delta is positive but smaller than a naked long call.
• Net vega is small, because the long and short legs partly cancel; the spread is much less sensitive to changes in implied volatility.
• Net theta depends on where the price sits. When the underlying is near K1, time decay usually hurts the spread; when it is near or above K2, time decay usually helps, because the spread moves towards its full width as expiry approaches.

Lot size and money figures. Exchange-traded options are traded in lots. Profit per lot = profit per unit × lot size. Lot sizes are set and revised by the exchange under regulator rules, so always take the current lot size from the exchange's official contract specification rather than from any textbook.

Settlement style. On Indian exchanges, index options such as those on the Nifty 50 are European-style and cash-settled, so they can be exercised only at expiry. Stock options on Indian exchanges are European-style and, at the time of writing, physically settled, meaning an in-the-money position at expiry can lead to delivery of shares. Confirm the current rules in the exchange's circulars before relying on them.

3. Let us work through it

Use this method for every vertical spread question.

Step 1 — Identify the legs. Write each leg: long or short, call or put, strike, premium. Confirm both legs have the same expiry and the same underlying.

Step 2 — Compute the net premium. Net debit = premium paid − premium received. If the answer is negative, you actually have a credit spread.

Step 3 — Find the width. Width = higher strike − lower strike.

Step 4 — Apply the three formulas. Maximum loss, maximum profit and breakeven, using the formulas for the correct spread type.

Step 5 — Build a payoff table. Choose five prices: well below the lower strike, at the lower strike, at the breakeven, at the higher strike and well above it. For each price, compute each leg's expiry value, add them, and subtract the debit.

Step 6 — Scale to lots. Multiply the per-unit result by the lot size, and add transaction costs (brokerage, exchange charges, taxes) as a separate line.

Step 7 — State the assumptions. Both legs held to expiry, no early exit, settlement at the official settlement price, and costs ignored unless stated.

5. Common mistakes and how to fix them

• Adding the two premiums instead of subtracting them. Fix: premium paid minus premium received gives the net debit; write the sign next to each leg.
• Mixing expiries or underlyings and still calling the position a vertical spread. Fix: check that both legs share the same underlying and expiry before applying any formula; different expiries make it a calendar or diagonal spread.
• Using the wrong strike for breakeven in a bear put spread. Fix: a bear put breakeven is the higher (long) strike minus the debit, not the lower strike plus the debit.
• Believing maximum profit equals the width. Fix: the width is the maximum value of the spread; subtract the debit to get the maximum profit.
• Ignoring lot size and costs. Fix: always convert per-unit numbers to per-lot figures and deduct brokerage, exchange charges and taxes separately.
• Forgetting settlement style. Fix: check whether the contract is European or American, cash or physically settled, from the exchange's contract specification.