The concurrent purchasing and selling of options of the identical type and same expiration date, but at various strike prices is the concept of vertical spread. The term vertical stems from the strike prices positions.
This contrasts with a calendar spread, which is a horizontal spread and represents the instantaneous buying and sale of the same option type with an identical strike price, but various expiration dates.
Learning the elements of the four types of vertical spreads, such as bull call, bull put, bear call, and bear put can be a solid method for understanding more advanced strategies for options trading. In order to use these strategies productively, investors have to understand which option spread to implement in a particular trading environment and stock situation.
Spread trading enables traders to reduce risk and cost as opposed to single options trading. There is an extra dimension, within spread trading, there are changes in time decay and implied volatility is not influencing the position more than previously.
Also Read: What Is Debit Spread? The Ultimate Guide
Contents
- Basic Features of Vertical Spreads
- Understanding Vertical Spreads
- Vertical Spread Types
- Vertical Spread in Options Trading
- Credit and Debit Spreads
- Which Vertical Spread to Implement
- Factors to Consider
- How Vertical Spreads Work?
- Example of a Bull Vertical Spread
- Managing Credit Spreads
- Reasons to Use Vertical Spread
- Other Types of Options Spread Strategies
- Benefits of the Vertical Spread Strategy
- Conclusion
- FAQs
Basic Features of Vertical Spreads
Every vertical spread is based on purchasing of puts or calls at a different strike price. The spread possesses two legs, one for purchasing an option, and then another for writing an option.
The result is an option position that enables an investor a credit or debit. With a debit spread, there is putting on the trade costs money. The option can cost $500, but the trader gets $400 from the other position. In this case, the net premium has a cost of $100 debit.
If the situation were altered and the investor gets $500 for putting on an option trade, and the other option costs $400, then the two option contracts create a net premium credit of $100.
Understanding Vertical Spreads
Investors can implement the vertical spread if they think that a modest move in the underlying asset’s price. Vertical spreads tend to be directional plays and can get created to represent the investor’s view, on the same underlying asset as bearish or bullish.
Concerning the vertical spread type that gets used, the account of the trader can be debited or credited. Because a vertical spread incorporates buying and selling, the revenue from writing an option will potentially offset part of the complete value of the premium needed to buy the other leg of the strategy, or purchase the option. The result is reduced expense and smaller risk trade.
But this reduced risk comes at a price, the profit from the vertical spread strategy is caped. The recommended investment or financial advice is for a trader to anticipate a substantial, trend-like move in the assets price in that case a vertical spread is not the best strategy.
Vertical Spread Types
There are a few versions of vertical spreads. We are going to examine the ones that can get subdivided into bears and bulls.
Bears
Bearish traders implement bear put spreads or bear call spreads. With these strategies, the investor
sells the option at the reduced strike price and purchases the option with the larger strike price. In this case, the bear put spread generates a net debit, and the bear call spread produces net credit to the account of the trader.
Bulls
Bullish traders implement bull call spreads and bull put spreads. In the two strategies, the investor purchases the option with a reduced strike price and sells it at the higher strike price. The option types are not the only difference, the main distinction is the cash flow timing. The bull call spread produces a net debit, and the bull put spread generates a net credit at the start.
Vertical Spread in Options Trading
Options can get sold to accumulate time premiums because the option becomes worthless if the date of expiration is out of the money by the expiration date. Being out of the money means the share price will stay under the maximum limit that the speculator has set.
We can look at a hypothetical example to get a better understanding, if the stock of ABC Corporation is trading at $500 per share, and the investor plant to wager that the market price stock will not go over $100 per share, and that is the entry price.
The investor can sell a $100 strike call option for $4, and if the option stays out of money until the date of expiration, then they will retain the credit receipt valued at $400 as profit.
But the risk is unspecified as the share price may go over $0 per share. The capital needed to sell the option can be very substantial.
Also Read: Options Trading Books
Credit and Debit Spreads
Vertical spreads get implemented for two reasons:
- For debit spreads, lower the payable premium amount.
- For credit spreads, to lower the risk of the option position.
We can examine the first reason. Options premiums tend to be pricey when the general market volatility is high. This can be the case even if a particular stock’s implied volatility is large.
The vertical spread limits the maximum gain that can get made from an option position, contrasted to the profit potential of a self-sustaining put or call or put, which will reduce the cost of the position.
This type of spread is easier to implement in periods of increased volatility because the volatility on one leg of the spread influences the other leg’s volatility.
But when credit spreads are under review, they can substantially minimize the risk of writing options, because option writers assume a large risk to make a small profit from the option premium. One unlucky trade can erase the positive results of many positive option trades.
Writing uncovered calls is a risky options strategy because potential losses are unlimited if the trade goes in an unwanted direction. Alternatively, writing puts is not as risky, but a persistent investor that has written puts on multiple stocks will get stuck with a big number of pricey stocks if the market collapses.
Credit spreads control this risk, but the reduced risk comes at the price of a smaller amount of option premium.
Which Vertical Spread to Implement
It’s advisable to implement a bull call spread if calls get pricey because of increased volatility and the expectation of medium upside than large profits.
This situation is typical for the later phases of a bull market when assets are close to a peak and gains are more difficult to generate. The bull call spread can be useful for a stock that possesses the long-term potential and large volatility because of a recent decline.
Plan to use a bear call spread if volatility is large and a small downside gets expected. This scenario is usually seen in the last stages of a bear market when stocks are closing on a trough, but volatility remains increased, and the reason is pessimism dominates.
Bull put spread can get implemented to get premium income in sideways markets, and purchase stocks at smaller prices when the market is turbulent. Purchasing assets at lower prices is possible when the put can get exercised to purchase the stock at the strike price, and credit was received, lowering the cost of purchasing the asset.
This strategy is great for collecting stock of high-quality at reduced prices when there is an unexpected period of volatility and the underlying trend is upward. The bull put spread is similar to purchasing the dips with an extra dimension of getting premium income in the deal.
Plan on implementing a bear put spread when medium to large downside gets predicted in stock and volatility is rising. Bear put spreads can get considered in periods of low volatility to reduce premiums paid, like for hedge long positions following a powerful bull market.
Factors to Consider
There are several factors that investors need to take into account when preparing a strategy for the present conditions and their outlook.
Bullish or bearish: Implementing stand-alone calls is a better option if you are bullish. However, when predicting a modest upside, then plan to use a bull call spread or a bull put spread. At the same time, if modestly bearish or hoping to minimize the expense of hedging long positions, the best solution may be the bear put spread or the bear call spread.
Volatility view: If volatility gets expected to decline or increase that investors have to factor this in. Because an increase in volatility can be an advantage for the option buyer, that prefers strategies that incorporate debit spread. Reduced volatility increases the chances for option writer that uses credit spread strategies.
Risk versus reward: Investors that aim for limited risk and greater profit this is more in line with the style of option buyers. Searching for limited rewards for larger risk is also in style with option writers.
The conclusion is that for bearish investors, consider rising volatility, and plan on limiting risk, in that case, the most opportune strategy is the bear put spread. And when moderately bullish, with declining volatility, and have no problems with the risk-reward payoff that it’s recommended to select the bull put spread.
How Vertical Spreads Work?
Vertical spreads function by enabling investors to perform directional trades while obviously defining, at entry the maximum profit for the trade as the biggest possible loss. One position balances the other and chooses if it’s a debit or credit spread.
Because the maximum loss is an order entry, there is a limited capacity for implementing defensive tactics. The max loss in a debit spread gets referred to as the order entry and losing positions cannot be defended. Yet in a credit spread the maximum loss is not known. Creating a situation that is crucial to managing the vertical spread in specific situations.
Example of a Bull Vertical Spread
The most opportune way to investigate the vertical spread is to look at an example. Investors that expect a stock to go higher can implement a bull vertical call spread. The trader purchases an option on X Computers, whose stock gets traded at $40 per share. Traders purchase in the money (ITM) option that has a strike price of $35 for $3 and sell an out-of-the-money (OTM) call with a strike price of $45 for $2.
If during expiration, X Computers stock trades at $39. In that situation traders will use the call, paying $35 and then selling for $39, netting a $4 profit. The sold call will expire worthlessly.
The profit of $4 that gets generated from the sale of the stock sale, with the $3 premium and less the $4 paid premium paid, leaves a $3 net profit for the spread.
Managing Credit Spreads
Investors that manage credit spreads can reduce the maximum loss and improve the largest profit potential. Traders can prepare alerts on the platform they use to enable them to easily manage their credit spreads.
It’s crucial to remember then when managing a credit spread is to not allow it to go ITM. This usually occurs when the long option possesses a larger value than the short option.
When the short option has more value than the long option, then spread out in time for credit. In this way, traders can accumulate more value from the received premium than if the investor has been paying in the buying position. That is why investors minimize loss but improve the profit potential.
Reasons to Use Vertical Spread
Several reasons are available to motivate traders to use vertical spread and not use simple purchasing and selling of options to advantage of the movement in the stock price.
Expectations
Investors will use a strategy if they forecast a small move in an asset’s price.
Protection in High Volatility Environment
If an investor predicts that the price of an asset will go in a direction, then chances are the market will make the identical expectations. This can cause implied volatility, producing a push in an upward trajectory of the price of the options. With purchasing and selling the option, traders benefit from the large premium, but also have to safeguard if the volatility influences both options.
Limited Risk
The best part about the strategy is that the max loss is what you have already paid. And the variation among the two strike prices less any credit that you got. The risk gets reduced, yet simultaneously the profit is also reduced. The maximum gain is the difference between the strike prices minus the paid amount. Alternatively, the credit got in case of vertical spread.
Lower Cost
Investors are always trying to locate strategies that will bring reduced costs. This is possible with the vertical spread. Because the strategy enables the correction of the premium, it will generate a reduced cost. However, it will reduce the profit potential.
Other Types of Options Spread Strategies
There are a couple of other option spread strategies apart from the vertical spread, the two alternatives are horizontal and diagonal.
A horizontal spread strategy is known as a calendar spread and implements long and short options with the same strike prices but various dates of expiration. The main goal of the calendar spread is to make gains from the products of time decay on two various expiry options. Time decay is the estimation of the decline in the price of the option over time.
The reason for this is that as closing at the expiration date it becomes more likely to time decay than longer-term options. Because of this the horizontal spread strategy an investor can implement a long-term option to balance losses sustained if a short-term option is expected to expire worthlessly, and profit from the longer-term option.
A diagonal spread strategy incorporated the same time joining short and long positions with two options from the identical type, however various expiration and strike prices. Diagonal spreads take advantage of time decay in the same way as a horizontal spread, yet they profit from movements in the price of an option for every point of movement in the market, which gets referred to as delta.
Benefits of the Vertical Spread Strategy
Investors can sell time premiums with the vertical spread instead of selling a naked option. It also makes it possible to reduce the risk and implement a smaller amount of capital.
In situations of selling a vertical spread, the maximum profit is easy if the net price for the spread is sold. On the other hand, the maximum loss, that is the trade’s capital requirement, is the difference between the width of the entry and the strike price.
Conclusion
Learning what option spread strategy to implement in various market situations can drastically increase the chances for success in options trading. Observe the present market conditions and plan the analysis. Chose what vertical spread is the most appropriate for the situation, and then take into account the strike prices that get implemented before making a trade.
The vertical spread definition is not complex, a vertical spread involves purchasing puts or calls at various strike prices. Every spread is composed of two legs, one for purchasing an option, and the other for writing an option.
It’s a great strategy for investors that are prepared to trade low returns for low risk. At the same time investors that foresee a moderate price move in the underlying asset can implement it. Investors should be aware that when expecting large price moves in the security, then this strategy may not be the best option.
Options trading provides a large spectrum of strategies that are elementary and complex. There is a large degree of unpredictability in the market, and the best plans can produce unfavorable results. If the asset goes over the expectations it raises the question if the investor can modify the approach.
Investors prefer to implement options because they get substantial flexibility. Researching various strategies, and using different scenarios decide the level of comfortable with risk and reward of selling spreads.
FAQs
What is a vertical spread example?
The trader purchases an option on corporation X Computers, whose stock trades at $100 per share. The trader purchase in the money (ITM) option with a strike price of $55 for $5 and sells an out of the money (OTM) call with a strike price of $65 for $4.
What is a vertical call spread?
The vertical spread is a strategy that incorporates simultaneous purchasing or selling of a put or call at the various strike price but on the same date of expiration.
Is a vertical spread bullish?
The vertical spread can be both bullish and bearish.
How does a vertical put spread work?
The vertical put spread involves purchasing or selling put and at the same time selling or purchasing a different put at the various strike price, but the identical date of expiration.
