Option Trading Strategy: Vertical Spreads

From StockTrader

A vertical spread is an option strategy where an investor buys an option while simultaneously selling an option of the same type with the same expiration date but at a different strike price.



Vertical spreads are useful to investors because they limit the risk involved in an options trade, but they also limit the profit potential.

From this article, investors will gain a basic understanding of the different types of vertical spreads that can be used in an investor’s playbook.

Vertical spreads can be created with either calls or puts and can be either bullish or bearish.

Bullish

The bullish vertical spreads are known as the bull call spread and the bull put spread. These spreads are designed to profit from an increase in the price of the underlying stock.

A bull call spread is when an investor purchases a call option that is “at-the-money” while simultaneously selling a call option with the same expiration date but at a higher strike price that is “out-of-the-money.” The potential profit from this strategy comes from owning the call option. Selling the other option reduces the cost for the option that is bought.

For example, assume a stock is trading at $20. An investor buys one call option with a strike price of $25 for a premium of $1 per share. Simultaneously, he sells one call option with a strike price of $27 for a premium of $0.50 per share. The total cost of the trade is $0.50 (1 – .50 = .50).

Assume the underlying stock moves to $28. Any movement above $27 is forfeited. Therefore, the total profit of this trade is $1.50 per share ((27 – 25) – .50 = 1.50).

A bull put spread is when an investor purchases a put option that is “out-of-the-money” while selling a put option with the same expiration date but at a higher strike price that is “in-the-money.”

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The put option with the higher strike price is more expensive than the put option with the lower strike price. Essentially, the trader sells the more expensive put option to pay for the less expensive put option.



The investor hopes that both options expire worthless with the rise in the underlying security’s price. If this happens, his total profit is the premium paid to him for selling the put option minus the cost of buying the other put option.

Bearish

The bearish vertical spreads are known as the bear call spread and the bear put spread. These spreads are designed to profit from a decrease in the price of the underlying stock.

A bear call spread is achieved by purchasing a call option that is “out-of-the-money” while selling a call option with the same expiration date but a lower strike price that is “in-the-money.” The potential profit gained from this strategy is the premium received when selling the option minus the cost of buying of the other option.

A bear put spread is achieved by purchasing a put option that is “in-the-money” while selling a put option with the same expiration date but a lower strike price that is “out-of-the-money.” The potential profit gained from this strategy is the difference between the two strike prices, minus the total cost of the option.

For example, assume a stock is trading at $20. An investor implements a bear put spread by buying one put option contract with a strike price of $25 for a premium of $5 per share. At the same time, he sells one put option with a strike price of $20 for a premium of $2. At this point the investor is at a loss of $3 per share.

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However, assume the stock closes below $20 at expiration. The investor will profit from the difference in strike prices, minus the total cost of the options. In this case, the investor will profit $2 per share ((25 – 20) – (5 – 2) = 2).

After looking at the descriptions of different vertical spreads, investors can see how they can profit from each. Investors should research each spread more specifically in order to get the best results possible when using these strategies.

— The Option Specialist

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About the Author: The Option Specialist