Now that you’re using spreads, you need to understand them inside and out. Knowing how to calculate the max loss of spreads is very important. If you don’t know the max loss of your spread, you might be setting up yourself up for a huge loss.
This post is going to teach you everything you need to know to calculate your max loss. The lessons here will apply to all types of bull and put spreads. You will learn how to calculate the max loss for both debit spreads and credit spreads.
Let’s start by looking at how to calculate the max loss of vertical debit spreads.
Max Loss Of Vertical Debit Spreads Explained
You need to understand the logic behind vertical debit spreads in order to calculate the max loss.
Basically, a vertical debit spread is just a long option position with a reduced cost basis. You create this position by buying a long option and then selling an option at a different strike. Your cost basis is reduced by the amount of premium you receive from the sale of the short option.
The max loss of a vertical debit spread is the same as the max loss for a long option position- your max loss is limited to the premium you paid to open the position.
So How Is The Max Loss Calculated?
Based on the structure of a vertical debit spread, it should be easy for you to calculate the max loss.
The equation for the max loss of a vertical debit spread looks like this:
(Long strike premium – Short strike premium) x 100 = Max Loss
Vertical Bull Debit Spread Example:
Suppose you’re interested in opening a bullish position on stock XYZ. XYZ is currently trading at 200. You think XYZ will definitely be above 220 next month. To capture as much of the upside as possible, you open the following position:
- You buy a call with a strike of 215 for 4.00.
- You sell a call with a strike of 220 for 2.00.
- The debit you pay is 2.00.
Following the format above, your equation looks like this:
(4.00 – 2.00) x 100 = $200
Your max loss for this vertical bull debit spread is $200.
Vertical Bear Debit Spread Example:
Suppose you’re interested in opening a bearish position on stock XYZ. XYZ is currently trading at 400. You think XYZ will definitely be below 350 three months from now. To capture as much profit as possible, you open the following position:
- You buy a put with a strike of 345 for 6.00.
- You sell a put with a strike of 220 for 4.00.
- The debit you pay is 2.00.
Following the same format from above, your equation looks like this:
(6.00 – 4.00) x 100 = $200
Your max loss for this vertical bear debit spread is $200.
Max Loss Of Vertical Credit Spreads Explained
Understanding how vertical credit spreads are constructed is necessary for you to be able to calculate the max loss.
Simply put, a vertical credit spread is just a short option position with a stop-loss. You create this position by selling an option and then buying an option at a different strike. Your max loss is the difference of the strike prices, minus the premium received.
So How Is The Max Loss Calculated?
You may be thinking that calculating the max loss of a vertical credit spread is going to be tricky, but it’s not. It is a lot easier to calculate than it sounds.
Here is what the equation looks like:
(Short strike – Long Strike – Credit received) x 100 = Max loss
Vertical Bull Credit Spread Example:
Suppose you’re interested in opening a bullish position on stock XYZ. XYZ is currently trading at 300. You think XYZ will definitely be above 330 next month. To capture as much of the upside as possible, you open the following position:
- You sell a put with a strike of 330 for 8.00.
- You buy a put with a strike of 300 for 3.00.
- The credit you receive is 5.00 (8.00 – 3.00).
Following the format above, your equation looks like this:
(330 – 300 – 5.00) x 100 = $2,500
Your max loss for this vertical bull debit spread is $2,500.
Vertical Bear Credit Spread Example:
Suppose you’re interested in opening a bearish position on stock XYZ. XYZ is currently trading at 500. You think XYZ will definitely be below 450 five months from now. To capture as much profit as possible, you open the following position:
- You sell a call with a strike of 450 for 9.00.
- You buy a call with a strike of 500 for 3.00.
- The credit you receive is 6.00 (9.00 – 3.00).
Following the same format from above, your equation looks like this:
(500 – 450 – 6.00) x 100 = $4,400
Your max loss for this vertical bear debit spread is $4,400.
Using A Spread Sheet To Calculate The Max Loss Of Spreads
If you are like me, you probably don’t want to waste your time hand calculating your max loss before every trade. It’s a complete waste of time when you could just plug the numbers into a spread sheet.
I’m going to show you how to create your own spread sheet for calculating the max loss of spreads.
Note: I prefer to create all of my spread sheets using Google Sheets so I can easily access them from any device.
Step 1: Structuring The Spread Sheet
Create a new spread sheet and make 4 different boxes. You will need these 4 boxes for 4 different calculations. Put each of the following in the 4 boxes:
- Vertical Bull Debit Spread
- Long Call Premium
- Short Call Premium
- Max Loss
- Vertical Bear Debit Spread
- Long Put Premium
- Short Put Premium
- Max Loss
- Vertical Bull Credit Spread
- Short Put Strike
- Long Put Strike
- Credit Received
- Max Loss
- Vertical Bear Credit Spread
- Short Put Strike
- Long Put Strike
- Credit Received
- Max Loss
Your spread sheet should look something like this:
Step 2: Adding The Equations To The Spread Sheet
This is the most important part of creating your spread max loss calculator! If you enter these equations wrong, your calculator will not be accurate!
The equations I am about to give will only work if you have your spread sheet set up the exact same way as mine. If you structured yours differently, you will have to adjust the equation accordingly.
Copy and paste the following equations into the cell right next to “Max Loss”:
- Vertical bull debit spread equation:
- “=(B3-B4)*100”
- Vertical bear debit spread equation:
- “=(E3-E4)*100”
- Vertical bull credit spread equation:
- “=((B9-B10)-B11)*100”
- Vertical bear credit spread equation:
- “=((E10-E9)-E11)*100”
Step 3: Using The Spread Sheet
To use the spread max loss calculator, simply enter the required information in the proper cells. The max loss will be calculated automatically once you enter the values.
Let’s use the information from the 4 examples in this post to test the calculator.
This is what it should look like:
Well done! Your calculator works and you are ready to go!
Wrapping It Up
There you have it, you now know how to calculate the max loss for spreads. The mystery of how your broker calculates the max loss has been solved! You even have your own calculator so you can figure it out on your own.
Did you like this post? Do you have your own calculator that you use? What could make this calculator better? Make sure to let me know!