Vertical Spreads Explained

vertical spread

What is a Vertical Spread

A vertical spread is a limited risk strategy, it involves selling a call option in the money and buying another call option out of the money. Both has the same expiration date, but with a different strike. You can create vertical spread with calls and or puts.

Advantages of vertical spreads

Vertical spread offer advantages over naked options. When you sell this you enter a defined risk trade. When using vertical spreads it offers you an unique ability to control the risk and reward of a trade. It allows you to determine many other factors like the break even price, your maximum gain, if you can’t avoid it your maximum loss, the maximum ROC Return On Capital, and even the odds of having a winning trade, all at the time we enter the position!

 

Vertical Spread Types

When you trade options we can categorize spread trades in a credit spread or a debit spread. Before I can tell what a debit or credit spread is I want to explain what a spread is. In the world of trading options there are almost no limits to the different types of trades that can be created. Most people start with trading simply buying a long call or long put. You have to be directional right to earn some profit. This is called a directional trade. Some investors might have sold puts to benefit from a price drop. To buy call options or to sell puts is called naked options. That is because there is nothing to limit the potential risk of the trade. By contrast, a spread trade consists of at least two options and in many cases more than two options.

 

Debit Spreads

A debit trade is one in which an option is purchased. As a directional trade, all of your investment is at risk. In order to limit the potential risk of the trade, another option will be introduced into the trade.

The purpose of adding this option is to reduce the amount of risk that is in the trade. Typically, the credit received from the sale of the option will reduce (cost basis) the price you payed for the long option.  In a debit trade the risk of the trade itself is the amount of money spent for the entire spread trade.

Because debit trades are typically structured around a long option, they are best suited for trending equities. Some sort of directionality is normally required for this trade to be profitable. Not so for the credit trade.

 

Credit Spreads

The primary instrument of a credit trade is an option which is sold. You create a short position. It doesn’t mater if it is a short put or a short call. The naked put or call has a quite high risk. To limit the risk we buy a similar type of option. The risk is now limited to the difference between the strike prices of the two options less the credit that we received when we sold the spread.

Simultaneously buying and selling options with different strike prices establishes a spread position. And when you receive more credit for the option you sold than for the option you bought, a net credit results. This is known as a vertical credit spread. By “vertical” we simply mean that the position is built using options with the same expiration months. With credit spreads you sell options to receive options premium. The stock price does not have to move to let you profit.  As long as the stock doesn’t hit your short strike price you can keep the whole premium. The stock may even lightly move against you and you still can make some profit.

Sell OTM Call Credit Spread in high IV environment. How do you make money? You do if the stock goes down you make profit of the short delta, If the stock goes up you make money of the volatility crush. What is the risk?  You may risk money because of the magnitude of the move.

 

 

Conclusion

A debit trade almost always requires a move of the stock. It can be bullish or it can be bearish but the equity needs to move. By contrast, a credit trade can be profitable in several ways. The passage of time in and of itself can take this trade to its maximum profit. It is profitable to enter a credit spread and sell option premium. The equity does not have to trend in order to be profitable. Read more on verticals like when to trade credit or debit spreads