Vertical Spread Strategy Explained
Published on January 21, 2016
Published on January 21, 2016
Vertical Spreads Strategies are one of the most versatile form of option trading strategies. Some of you by now have become really good at Options Trading using Vertical Spreads for Income. But if you’re still struggling to nail Vertical Spread strategy, or if you’re just getting started in options trading world, this comprehensive article is most definitely for you.
Let’s kick off the New Year with an absolute game changer in your Options Trading. I’ve put a lot into this article for you, so make sure to read completely and ask questions to get everything you need to start the new year off successfully!
In this Vertical Spread focused article, you are going to learn:
Vertical spread is an option spread strategy whereby an option trader purchases a certain number of options and simultaneously sells an equal number of options of the same class, same underlying security, same expiration date, but at a different strike price.
In Vertical Spread, when one option is making money, the other option is losing money and thus Vertical spreads limit the risk involved but at the same time they reduce the profit potential.
Vertical Spreads can be either Debit Spread or Credit Spread, and can be created with either all calls or all puts. Vertical Spreads can be bullish or bearish.
Bull vertical spread is an options trading strategy designed to profit from a rise in prices of the underlying asset we’re trading. It can be constructed in two ways:
When structured for similar strike prices, similar expiration, both Bull Put Spread and Bear Call Spread have similar risk/reward profile. Attached option table below, that shows Apple Inc. (AAPL) Vertical Spreads real-time prices, confirms the same.
One may choose either of the two of vertical spreads to trade his directional view. However, it is much better to structure a trade based on Bid/ask slippage and Ease of fill. Based on my experience, it is a good idea to structure a Vertical Spread using “out of the money” options for better fills. Using an example let’s review Bullish Vertical Spread first, along with possible outcomes (profit and loss). We will use a hypothetical example on a stock which is currently trading at $48 per share. For our example, let’s assume:
Here is the price chart marked with entries for selecting spread using Call Options:
Here is the visual representation of the risk/reward profile at expiration to explain what we just described above: Notice the X-Axis i.e. the stock price axis to see how price movement affects our profit/loss. As our purchased call option ($50.00 strike price) is getting “in the money”, our loss is being reduced. Once the price moves above the $50.30 value, we start profiting. That profit increases up to a price of $52.50, where our short option is placed. Notice how a further increase in price (for example it can move to $60 per share) doesn’t affect our maximum profit which is capped at $220. Vice versa, notice what would a potential decrease in stock price to $0 mean for our vertical spread – you’re correct – it doesn’t affect our loss amount.
In this case, we will make maximum gains. The profit will be calculated based on intrinsic values of each option at expiration.
Since each option controls 100 shares, our gains will be $2.20*100 = $220. That’s +733% gains ($220 / $30 = 733%)
In this case, we will make maximum loss. The loss, just like profit, will be calculated based on intrinsic values of each option at expiration.
Since each option controls 100 shares, our loss will be $0.30*100 = $30. Remember, this value actually represents our initial investment and thus 100% loss.
In this case, profit or loss will again be calculated based on intrinsic values of each option at expiration.
Since each option controls 100 shares, our gains will be $0.70*100 = $70. That’s +233% gains ($70 / $30 = 233%)
First, we will sell Put option with a higher strike price at $52.50, and simultaneously, we will buy equal amount of Put option with a lower strike price at $50.00. Let’s assume that these two transactions, when combined, gave us $2.20 credit – since options come in lots of 100, our credit received for this bull put spread is $220. We are not allowed to consider this amount as our profit (yet) since it is only initial credit we received for constructing our spread in this manner. Assuming underlying price is in our favor, our profit will accumulate gradually and only materialize on expiration.
It is because we are comparing the risk/reward profile with respect to Bull Call Spread and we are using the same strikes. By setting up two options in this manner, we have constructed (or sold) a Bull Put Spread and we collected $220 credit. Since it gave us credit to open this spread, it is called a Credit Spread. In this case our Initial Credit (Ic) is $2.20 (or $2.20 * 100 = $220) Here is the same chart marked with profit/loss areas according to potential price movement by expiration date: Next, let us show what happens with our profit/loss when a stock price moves in different directions as we are nearing our expiration date.
In this case, we’ll make maximum gains. The profit will be calculated based on intrinsic values of each option at expiration.
Since each option controls 100 shares, our gains will be $2.20*100 = $220. That’s +733% gains ($220/$30 = 733%). We get to keep all the credit we collected to open this trade.
In this case, we’ll make maximum loss. The loss, just like profit, will be calculated based on intrinsic values of each option at expiration.
Since each option controls 100 shares, our loss will be $0.30*100 = $30.
In this case, profits or loss will again be calculated based on intrinsic values of each option at expiration.
Since each option controls 100 shares, our gains will be $0.70*100 = $70. That’s +233% gains ($70/$30= 233%)
As you may notice, in both cases, the profit/loss (risk/reward) was same whether you chose Bull Put Spread or Bull Call Spread using the same strikes. However, as mentioned earlier, it is much better to structure a trade based on bid/ask slippage and ease of fill, and thus it will be much better to use Bull Call Vertical Spread vs Bull Put Spread. Out of the Money Calls will be much easier to be filled vs Deep In the Money Puts and bid/ask slippage will also be relatively smaller.
This post covers only BULLISH VERTICAL SPREADS. In the following post, I will cover BEARISH VERTICAL SPREAD and provide you more examples so you could follow through.
Finally, I have to remind you to be patient with yourself. This isn’t all going to fall into place tomorrow. My goal is to give you a roadmap and a bunch of examples, so you see where you want to go with your options trading and have the skills to get there day by day.
How do you like it? What additional thoughts or questions do you have? I will answer every question, no strings attached. Make sure to leave your comments or questions so you can make the most of your learning.
Profitable Trading, OP