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What Is a Vertical Spread?
A vertical spread is a popular options trading strategy that involves buying and selling two options of the same type with different strike prices but the same expiration date. Its purpose is to limit potential losses while still participating in the market's movement, making it an attractive choice for risk-averse traders.
The importance of a vertical spread lies in its ability to offer a controlled risk-to-reward ratio, making it an effective tool for managing risk in a portfolio. By utilizing a vertical spread, traders can set specific profit and loss targets while taking advantage of price movements in the underlying asset.
Table of contents
- Vertical spreads are a popular options trading strategy traders use to profit from a bullish or bearish market while limiting potential losses.
- The strategy involves buying and selling two options of the same type with different strike prices and the same expiration date, resulting in a net debit or credit.
- The primary advantage of a vertical spread is its ability to offer a controlled risk-to-reward ratio, making it an effective tool for managing risk in a portfolio.
- Vertical spreads can be further categorized as bullish or bearish, depending on the direction of the trader's market outlook. Depending on the trader's strategy, they can be used with either calls or puts.
Vertical Spread Explained
A vertical spread is a type of options trading strategy that involves buying and selling two options of the same type (either both calls or both puts) with different strike prices but the same expiration date. The options are structured so that the higher strike price option is sold and the lower strike price option is bought, resulting in a net debit or credit to the trader's account.
The primary advantage of a vertical spread is that it allows traders to limit their potential losses while still participating in the market's movement. The downside, however, is that the potential profit is also limited, as the maximum profit is the difference between the strike prices of the options minus the premium paid or received.
Types
There are two main types of vertical spreads:
- Bullish vertical spread: This involves buying a call option with a lower strike price and selling one with a higher strike price. The goal is to profit from a rising market with limited risk and limited profit potential. This strategy is often used when a trader is moderately bullish on an underlying asset.
- Bearish vertical spread: This involves buying a put option with a higher strike price and selling a put option with a lower strike price. The goal is to profit from a falling market with limited risk and limited profit potential. This strategy is often used when a trader is moderately bearish on an underlying asset.
A bullish vertical spread involves buying a call option with a lower strike price and selling one with a higher strike price. In comparison, a bearish vertical spread involves buying a put option with a higher strike price and selling a put option with a lower strike price.
The options, including calls and puts, can also categorize vertical spreads. For example, a vertical call spread involves buying and selling call options, while a put vertical spread involves buying and selling options. The specific type of vertical spread used will depend on the trader's market outlook and trading objectives.
Examples
Let us look at the following examples to understand the concept better.
Example #1
Let's say stock XYZ is currently trading at $100 per share, and a trader believes it will rise to $110 over the next month. So they decide to enter a bullish vertical spread by buying a call option with a strike price of $100 for $3 per share and selling a call option with a strike price of $110 for $1 per share, resulting in a net debit of $2 per share.
If the stock rises to $110 by expiration, the call option they bought will be worth $10, resulting in a profit of $7 per share. However, the call option they sold will also be worth $0, resulting in a loss of $1 per share. Their net profit will be $6 per share ($7 profit - $1 loss) minus the initial net debit of $2, resulting in a total profit of $4 per share. If the stock doesn't reach $110 by expiration, its potential losses are limited to the initial net debit of $2 per share.
Example #2
Suppose a wheat farmer is worried that the price of wheat may drop in the next few months. So they enter a bearish vertical spread using put options on wheat futures to hedge your risk.
They buy a put option with a strike price of $550 for $10 per bushel and sell a put option with a strike price of $500 for $4 per bushel, resulting in a net debit of $6 per bushel. If wheat prices drop to $500 by expiration, the put option they bought will be worth $50, resulting in a profit of $40 per bushel. However, the put option they sold will also be worth $50, resulting in a loss of $46 per bushel. Therefore, their net profit will be $-6 per bushel ($40 profit - $46 loss), equal to the initial net debit of $6.
If the price of wheat doesn't drop to $500 by expiration, the farmer's potential losses are limited to the initial net debit of $6 per bushel. Using a bearish vertical spread, they can limit the potential losses while still participating in the market's movement, making it an effective hedging strategy for farmers and other commodity producers.
How To Close?
To close a vertical spread, one can take one of two actions: either buy back the option they sold and sell the option they bought, or they can let both options expire.
If one buys back the option they sold and sells the option they bought, this will close the position and realize their profit or loss. They can do this by placing an order with the broker before the expiration date. The profit or loss will be the difference between the price they paid to buy back the option sold and the price they received from selling the option bought, minus any transaction fees or commissions.
If they let both options expire, they will be automatically exercised if they are in the money. If they are out of money, they will expire worthless, and they won't be required to take further action. However, if one or both options are in the money, they may need to take action to close the position before expiration to avoid being assigned the underlying asset.
It's important to remember that options trading involves risks and may not be suitable for all investors. Therefore, before entering any options trade, it's important to understand the risks and consult a financial advisor.
Vertical Spread vs Horizontal Spread
Let us have a look at the table comparing vertical spreads and horizontal spreads in options trading:
| Basis | Vertical Spreads | Horizontal Spreads |
|---|---|---|
| Definition | Buy and sell options of the same type with different strike prices but the same expiration date. | Buy and sell options of the same type with the same strike price but different expiration dates. |
| Risk and Reward | Limited profit potential and limited risk | Unlimited profit potential and limited risk |
| Cost | Generally cheaper to enter | Generally more expensive to enter |
| Breakeven point | Closer to the current market price | Further from the current market price |
| Strategy | Used for directional trades | It can be used for both directional and volatility trades |
| Time Decay | Less affected by time decay | More affected by time decay |
| Example | Bull Call Spread or Bear Put Spread | Calendar Spread or Time Spread |
Vertical Spread vs Diagonal Spread
Let us have a look at the table comparing vertical spreads and diagonal spreads in options trading:
| Basis | Vertical Spreads | Diagonal Spreads |
|---|---|---|
| Definition | Buy and sell options of the same type with different strike prices but the same expiration date. | Buy and sell options of the same type with different expiration dates and strike prices. |
| Risk and Reward | Limited profit potential and limited risk | Unlimited profit potential and limited risk |
| Cost | Generally cheaper to enter | Generally more expensive to enter |
| Breakeven point | Closer to the current market price | Further from the current market price |
| Strategy | Used for directional trades | It can be used for both directional and volatility trades |
| Time Decay | Less affected by time decay | More affected by time decay |
| Example | Bull Call Spread or Bear Put Spread | Calendar Spread or Double Diagonal Spread |
Frequently Asked Questions (FAQs)
You must have a brokerage account that allows options trading to trade vertical spreads. Select the appropriate options, strike prices, and expiration dates, and place your trade.
Vertical spreads can be profitable if executed correctly, and the market moves in the trader's anticipated direction. However, profits are limited by the maximum potential gain of the spread.
Traders can let vertical spreads expire if they prefer. Still, it is recommended to close the position before expiration if it is in the money or if there is a risk of being assigned the underlying asset.
In the United States, vertical spreads are generally taxed as short-term capital gains or losses if the position is held for less than a year or long-term capital gains or losses if held for more than a year.
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