Trading Vertical Option Spread
A very lucrative way to get income from options on a regular basis is by selling vertical call or vertical put spreads. They are also known as credit spreads.
Vertical spreads are simple to apply and to analyze. But the greatest asset of a vertical spread is that it allows you to choose your probability of success for each and every trade.
Whether you choose a vertical call or put spread, they have a defined risk. So, You always know how much you can make or lose on each and every trade.
What I like of selling vertical spread is that I may be wrong on my assumption of direction and still make a profit. A lot of people don’t know of this advantage that vertical spreads offer.
Why use a vertical spread?
A vertical spread is primarily a directional play. A vertical spread with positive or negative delta will remain so no matter where stock moves. Unless one of the options is at-the-money and the other far from it, changes in volatility will not have a huge effect on a vertical spread. Below you will see the profit risk graph of a bull vertical and a bear vertical spread.
Vertical spreads can be used to increase your probability of profit and reduce your exposure to high premium and implied volatility.
One of the issues with buying naked calls and puts is that by the time you buy them, the premium is already high. The higher the premium is, the lower the probability of profit for the buyer. So to lower your exposure to those high premiums, you should know when to spread ’em.
Vertical Spreads are used to offset premium costs when buying options, or to hedge risks when selling options.When you enter the trade you know the maximum gain and risk beforehand. This kind of trade is a low risk strategy and allows a very specific risk management. Verticals are usually used when implied volatility, and therefore option premium, is high.
Bull Vertical Spreads
Call Spreads are used when the option trader is bullish on the underlying security. You benefit from a rise in the price of the underlying asset. You can make spreads with calls or puts. They are known as bull call spread and bull put spread respectively.
If you look to the graphs you will see that they have similar risk/reward profiles. The bull call spread is bought for a debit. And when we enter a bull put spread we receive option premium for a credit. The bull call spread is also called a vertical debit spread. And the bull put spread we also call a vertical credit spread.
Bull Call Spread (debit Spread)Buy ITM Call + Sell OTM
Bull Put Spread (Credit Spread)Sell OTM Put + Sell further OTM Put
Bear Vertical Spreads
Vertical spreads are also available for the option trader who are bearish. Traders use Bear vertical spreads to profit from a drop in the price of the underlying asset. You can setup this trade with calls or puts. The name for these spreads are bear call spread and bear put spread respectively.
While both spreads have similar risk/reward profiles. When you enter a bear call spread you will receive option premium. While the bear put spread can be entered for a debit. The bear call spread is also called a vertical credit spread. And the bear put spread is also referred to as a vertical debit spread.
Bear Call Spread (credit Spread)
Sell OTM Call + Sell further OTM call
Bear Put Spread (debit spread)
Buy ITM Put + Sell OTM