Options trading vertical

If we are moderately bullish on an underlying stock, we can construct a call spread by purchasing a call option with a strike price near the stock price, typically at-the-money or one strike out-of-the-money, and sell one out-of-the-money call option with a higher strike price, typically and one or two strikes higher than the long call option. The position is bullish because the value of the position goes up as the price of the underlying goes up.

Vertical Spread Overview

This type of spread is also known as a debit spread because the premium of the long call is higher than the premium of the short call, and our account is debited by this difference. This is also known as a parity graph. With a bull call spread, the most a trader can lose is the net premium paid. However, to be profitable, the price of the underlying needs to move up.

The position is not profitable until the stock price reaches the point where it is equal to the strike price of the long call plus the premium paid. At this point, the intrinsic value of the long call is equal to the price paid for the spread. As the stock price continues to move higher, the value of the spread increases until it reaches its maximum value at the strike price of the short call.

At this point the maximum value of the spread is the difference between the two strike prices, and the maximum profit is the value of the spread minus the premium paid. If we are moderately bearish on an underlying stock , we can construct a put spread by purchasing a put option with a strike price near the stock price, again typically at-the-money or one strike out-of-the money; and sell one put option with a lower strike price, typically one or two strikes lower than the long put option.

Since the premium of the long put is higher than the premium collected for the short put, this creates a debit spread. This is considered a long put spread, but since the position is bearish the value of the position goes up as the price of the underlying goes down , this creates what is known as a bear put spread. With a bear put spread, the most a trader can lose is the net premium paid, and just like the bull call spread, the position is not profitable until the stock price moves in the desired direction, which is lower. Break-even is reached when the stock price drops to the strike price of the long put minus the premium paid.

As the stock price moves lower, the value of the spread increases until it reaches the strike price of the short put, at which point the value of the position reaches its maximum value, which is the difference between the two strike prices, and maximum profit is achieved, which is the value of the spread minus the premium paid.

With these first two positions, we were either moderately bullish or moderately bearish, and the stock price was required to move in the correct direction in order to make a profit. If we are willing to accept less profit, and a little more risk, we can use options to construct vertical spreads that profit even if the stock price does not move in our direction.

For instance, if we are only somewhat bullish to neutral on an underlying stock, we can construct a put spread by selling a put option one strike out-of-the money; and buy one put option with a lower strike price, typically one or two strikes lower than the short put option.

Since the premium collected on the short option is larger than the premium paid for the long option, our account is credited with this difference, and the spread is known as a credit spread. We are short the spread, but this position is considered bullish because a profit is realized if the underlying stock goes up in value. With a bull put spread, the maximum profit achievable is the initial credit collected at order entry. The position remains profitable as long as the stock price does not drop below the break-even price which is determined by subtracting the credit received from the short put strike price.

If the price continues to drop, losses increase until a maximum loss is reached at the long option strike price. At this point, the maximum value of the spread is reached, which is the difference between the two strike prices, and the maximum loss is the spread minus the initial credit collected.

This spread has a greater probability of being profitable because the stock price can go up, stay the same, or even go down a little , but the profit is smaller than a bull call spread, and the losses can be greater. Finally, if we are somewhat bearish to neutral on an underlying stock, we can construct a vertical call credit spread by selling a call option one strike out-of-the money; and buy one call option one or two strikes higher than the short call option.

This creates what is known as a bear call spread. Again, since the premium collected on the short option is larger than the premium paid for the long option, our account is credited with this difference. We are short the spread, and this position is considered bearish because a profit is realized if the underlying stock goes down in value. Just like the bull put spread, with a bear call spread, the maximum profit achievable is the initial credit collected at order entry. The position remains profitable as long as the stock price does not move higher than the break-even price, which is determined by adding the credit received to the short call strike price.

If the price continues to rise, losses increase until a maximum loss is reached at the long option strike price. At this point, the maximum value of the spread is reached, and the maximum loss is this spread minus the initial credit collected. This spread also has a greater probability of being profitable because the stock price can go down, stay the same, or even go up a little , but the profit is smaller than a bear put spread, and the losses can be greater.

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Because option pricing is based on a robust mathematical model that takes into consideration the probabilities of reaching specific price levels, vertical spreads offer the trader the ability to determine probabilities of having a winning trade by contract expiration. There is an inverse relationship between the maximum profit achievable and the probability of achieving that profit , i.

Since the maximum value of a vertical spread is the difference between the two strike prices, the probability of a winning trade can be calculated by dividing the maximum loss by the width of the spread. The trade off in selecting a trade with a higher probability is that there is a direct relationship between the probability of winning and the potential loss, i. The advantage of trading vertical spreads is that all of these metrics can be determined at order entry. Commissions are not included for simplicity. The first column is a debit spread where a bear put spread is purchased.

Using the formulas defined above, the table shows the impact that the larger spreads have on all the calculations. The first column is a debit spread where a bull call spread is purchased. The next column shows the results for selling a bull put spread for 0.

Vertical Option Spread Trading Pros and Cons

They get their name from the fact that these spreads are created using two options within the same expiration month, but with different strike prices, which are typically listed vertically on most options quote screens. Hence the name "vertical spreads. Options spreads can be long or short and created with either puts or calls.

In most cases, the investor has a directional view and expects the stock to move higher or lower. For example, in a long call vertical spread, which we discuss here, the investor is typically bullish and is positioning for a rally in the stock. Other verticals include short call vertical spreads, short puts vertical spreads, or long put vertical spreads. Remember, a call buyer enters a contract and has the right to buy the underlying stock at a fixed price through the expiration.

Most investors understand that this call costs money, known as a premium or debit, and that the entire investment is at risk if the stock heads south rather than north. A long call vertical spread is also a bullish strategy, but the investor is buying one call option and selling another at a higher strike price with the same expiration date. While the long call costs a premium to purchase, the investor is also selling a higher strike call and the premium collected on this short call helps offset some of the cost of the purchase of the long call.

Nevertheless, like a long call, the investor pays a debit and that investment is at risk. Figure 1 shows a typical risk-reward profile for a long call vertical spread.