What is a vertical spread?
Buying and selling options of the same kind (calls or puts) simultaneously expiring at separate strike prices is known as a vertical spread. The striking pricing’s location is where the word “vertical” originates.
A horizontal spread, also known as a calendar spread, is the simultaneous purchase and selling of an identical kind of option with a different expiry date and strike price.
Understanding Vertical Spreads
When traders anticipate a slight change in the underlying asset’s price, they use a vertical spread. Vertical spreads are mostly directional bets that may be adjusted to indicate a trader’s optimistic or bearish attitude toward the underlying asset.
The trader’s account may be credited or debited, depending on the kind of vertical spread used. The earnings from writing an option will partly or entirely cover the premium needed to buy the second leg of this strategy, which is purchasing the choice since a vertical spread entails both a purchase and a sale. The outcome is often a lower-cost, lower-risk transaction than a naked options position.
A vertical spread approach would, however, also constrain the profit potential in exchange for reduced risk. Investors should not use a vertical spread strategy if they anticipate a significant, trend-like change in the underlying asset’s price.
Vertical Spread Types
Vertical spreads come in a variety of forms.
Horns
Bullish traders use bull call and bull put spreads as instruments. The trader purchases the option with the lower strike price and sells the option with the higher strike price in both methods. The timing of the cash flows is the primary source of variance, apart from the differences in option types. The bull put spread first generates a net credit, whereas the bull call spread initially generates a net debit.
Hauls
Bearish traders make use of bear call and put spreads. When using these techniques, the trader purchases the option with the higher strike price and sells the option with the lower strike price. In this case, the trader’s account experiences a net credit from the bear call spread and a net debit from the bear put spread.
Calculating Profit and Loss from Vertical Spread
Not a single case mentions commissions.
Bull call spread: the net debit from the premiums
- Net premium paid: the difference between strike prices equals maximum profit.
- Max loss equals paid net premium.
- The long-call strike price plus the net premium paid equals the breakeven point.
Bear call spread: The premiums result in a net credit.
- The net premium obtained equals the maximum profit.
- The maximum loss is equal to the difference between the strike and net premiums.
- The breakeven point is the short call’s strike price plus the net premium received.
Bull put spread: a net credit is produced by the premiums.
- The net premium obtained equals the maximum profit.
- The maximum loss equals the difference between the strike and net premiums.
- The breakeven point is the short put’s strike price less the net premium received.
Bear put spread: (the premiums generate a net negative)
- Net premium paid: the difference between strike prices equals maximum profit.
- Max loss equals paid net premium.
- Breakeven point = the strike price of a long put minus the net premium paid.
An Actual Bull Vertical Spread Example
An investor who wants to place a wager on a rising stock uses a bull vertical call spread. The investor has the option of purchasing Company ABC stock, which costs $50 per share. An out-of-the-money (OTM) call option with a strike price of $55 is sold for $3, and an in-the-money (ITM) option with a $45 strike price is purchased for $4.
The shares of Company ABC trade at $49 at expiry. In this scenario, the investor would exercise their call, paying $45 and selling for $49 to make a $4 profit. The call that they sold expires at zero value.
There is a $3 net profit for the spread after deducting the $4 premium paid from the $4 profit from selling the shares and adding the $3 premium.
Conclusion
- Purchasing (selling) one call (put) and concurrently purchasing (selling) another call (put) at a different strike price but with the same expiry is known as a vertical spread in the world of options trading.
- Bear vertical spreads benefit from a price drop, and bull vertical spreads gain value as the underlying asset appreciates.
- Vertical spreads provide a limit on possible returns as well as risk.
