Vertical Spread is one of the options trading strategies that primarily help to cover a risk. Moreover, it also helps to profit from any movement in the stock price, be it an increase, decrease, or even a sideways movement.
Under vertical spread strategy, a trader buys and sells the same type of options (call or put) with the same expiry date but having a different strike price. Though such a strategy helps lower the risk involved, it also lowers the profit potential.
We can say that such a strategy is a directional play. And a trader can customize it to reflect their view (bearish or bullish) of the market or the security.
Reasons to Use Vertical Spread
Following are the reasons why you will want to use vertical spread rather than going with simple buying and selling of options to benefit from the movement in the stock price:
Traders will go for such a strategy if they expect a moderate move in the price of the security.
The maximum you can lose in such a strategy is the amount you paid (debit vertical spread). Or the difference between the two strike prices less any credit that you got (credit spread). As said above, the risk is less, but at the same time, the profit potential is also less. The maximum return you can get is the difference between the strike prices less the amount paid (debit vertical spread). Or the credit received in case of credit vertical spread.
Safe in High Volatility Environment
If a trader expects the price of a security to move in one direction, then there are good chances that the market would also have the same expectations. This would lead to implied volatility, resulting in pushing the price of the options up. So, by buying and selling the option, you not only benefit from the high premium, but you also get to save yourself if the volatility affects both options.
Since this strategy helps to offset (fully or partially) the premium, it results in lowering the cost. However, as said above, it also limits the profit potential.
Types of Vertical Spread
Since vertical spreads involve both call and put options and can represent both bullish and bearish views, there can be four types of vertical spreads:
Bull Call Spread
As the name suggests, it is on the basis of bullish expectations and uses call options. One can also call it call debit spreads or long call spreads. In this, a trader buys a call option and also sells the call option (with the same expiration cycle) at a higher strike price. The trader makes a profit when the price of the security rises as this pushes the call spread’s value up as well. A trader should go for this strategy if they believe the stock price to rise, but not higher than the strike price of the call they sell.
Maximum Profit = Difference in the spread between the strikes prices Less Net premium
Maximum Loss = Net premium that the trader pays
Breakeven = Long call’s strike price Plus Premium paid
Bear Call Spread
As the name suggests, it is a bearish strategy involving two call options. One can refer to it as a short call spread or call credit spread as well. Under this, a trader sells a call option and also buys a call option (with the same expiry) with a higher strike price. The trader makes a profit when the share price drops or if the share price remains below the breakeven price at the time of expiry. Also, traders can sell if they expect the price of the share to drop or trade sideways through the expiry date.
Maximum Profit = Premium that the trader gets
Maximum Loss = Spread width or the difference between the spreads. Less Premium trader gets
Breakeven = Strike price of the short call Plus the premium that the trader pays
Bear Put Spread
A trader uses this strategy if they expect the share price to drop but not below the strike price of the short put. One can also call it put debit spreads or long put spreads. Under this, the trader buys a put option and also sells another put option with the same expiry but with a lower strike price. The trader makes a profit if the share price drops. This would push the put spread’s value up.
Maximum Profit = Difference or spread between the strike price Less Premium that trader pays
Maximum Loss = Net premium that trader pays
Breakeven = Strike price of long put Less Premium that trader pays
Bull Put Spread
In this strategy, a trader sells a put option and also buys another put option with the same expiry but with a lower strike price. One may also call such a strategy as short put spread or put spread strategy. A trader makes a profit if there is an increase in the share price or the share price stays above the strike price of the put sold until the expiry. A trader can sell the put spread if they expect the share price to increase or trade sideways throughout the expiration date.
Maximum Profit = Premium that trader gets
Maximum Loss = Difference between strike price or spread width Less Premium trader gets
Breakeven = Strike price of short put Less Premium trader gets
Volatility and Expiry
Predicting the stock movement could be very difficult. However, a trader can look for the volatility (daily/monthly moves) in the stock. This would help them in selecting an appropriate strategy.
Talking about choosing an expiration date, vertical spreads can hit maximum profit potential only when the extrinsic value reaches zero. Usually, traders go for expiration between 30-60 days for most options strategies. This allows them to get the best of time decay and also enough time to recover the trade if it goes unfavorable initially.
Vertical Spread is an appropriate strategy for traders who are willing to trade low returns for low risk. Also, it is apt when traders expect a moderate move in the price of the underlying asset or security. However, if a trader expects any substantial move in the price of the security, then this may not be an appropriate strategy to use.