Vertical spreads provide known and fixed maximum gains and losses.
They are usually used with high implied volatility and/or high premiums.
They can be credit or debit spreads.
They increase the probability of profit with directional trades, but limit the upside.
Would you like to...
- Be able to increase your probability of profit?
- Reduce your exposure to high premiums and implied volatility?
One of the issues with buying "naked" calls and puts is that by the time you purchase them, the premiums are already very high. As options trading is a probability game, the higher the premiums are, the lower the probability of profit for buyers. 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. The maximum gain and risk are known from the outset of the trade, and therefore allow for very specific risk management. Verticals are usually used when implied volatility, and therefore option premiums, are high.
What is a Vertical Spread?
Vertical spreads, a strategy done with either calls or puts, involve buying one option and selling another option of the same type and expiration, but a different strike.
A "bull call" spread, for example, entails buying one call and selling a higher-strike, lower-priced call to offset some of the premium cost. This type of spread would be done for a debit. A "bear call" spread would entail selling the lower-strike call and buying a higher-strike call to hedge the risk. This would produce a credit in your account; cash will be held as a margin for the position.
Debit vertical spreads (bull call and "bear put" spreads) profit from a directional move. The position will succeed if the stock has moved past the bought strike plus the debit paid. For a full profit, the underlying needs to move beyond the sold strike by expiration. For example, if XYZ call spread is purchased, buying the 25 call and selling the 30 call for a debit of $2, then the full profit will come with the underlying anywhere above 30, and the position will profit anywhere above 27.
Credit vertical spreads involving calls will make a full profit if the underlying is below the sold strike at expiration. The break-even is the strike plus the credit. Credit spreads using puts will profit if the underlying stays above the strike sold minus the credit. Example: Sell the XYZ 30 put, buy the 25 put to hedge the risk, for a credit of 2.50. The position will profit anywhere above 27.5, and will get a full profit if XYZ is anywhere above 30 at expiration.
Vertical spreads lose if the underlying moves in the wrong direction. The maximum loss for debit spreads is the debit paid. The maximum loss for credit spreads is the difference between the two strikes used minus the credit. This is also the amount of margin held by your broker.
Debit vertical spreads are used to offset the premium cost of the purchased option, especially when implied volatilities are high. This increases the probability of profit for the trade, but does limit the potential gains. Credit spreads are used when one wants to be a net seller of options, but wants to hedge the risk. Option selling can have a very high probability of profit, but also the potential for large losses, and using a credit spread limits that exposure.
With the stock at 149, the 150 call is purchased for $10, and to offset some of that cost, the 160 call is sold for $6, for a net debit of $4.
This is a directional trade, so the bull call spread will profit from the stock moving up and lose from the underlying moving down. The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management. The spread is used to limit exposure to implied volatility, so changes in implied volatility will have little effect. Time is against you with a debit spread, and for you with a credit spread.
Example of a Winning Trade
- Intel's (INTC) price bounces off resistance at the same time that implied volatility spikes. We usually buy call spreads on high implied volatility to offset the premium cost.
- With the stock at 23.50 and rising in mid-August, we would buy the September 22.50 calls for $2.00 and sell the 25 calls for $.85, for a net debit of $1.15.
- The maximum risk is the $115 we paid (remember: shares in option lots come in 100s), realized if the stock is below 22.50. The maximum gain is $135.
- In this case, INTC went up to 26, so the trade worked out perfectly, giving us a 117% return. The stock went higher than 25, but we were still better off with the spread.
Example of a Losing Trade
- Here the price of the underlying asset moved against our position.
- In late July, we seemed to have the price bottoming out, accompanied by a spike in implied volatility. When the price broke back above 48 and implied volatility started to fall, we bought the August 49 call for $.80 and sold the 50 call for $.50, for a net debit of $.30.
- After a quick move in our direction, the price dove down to below 46.
- We held the position and at expiration, we lose the debit we paid of $30.