Feeling pretty experienced with trading long calls, long puts, and writing covered calls? Vertical spreads are one of the building blocks of options trading, and they can be a logical next step.
Depending on its construction, a vertical spread can be either bullish (benefiting from a rise in the underlying’s value) or bearish (benefiting from a decrease in the underlying’s value). If you’re looking for an option strategy that is designed to take advantage of directional moves but with defined risk, the vertical spread could be the answer.
There are different types of vertical spreads, but their mechanics are similar. A call vertical, for example, involves simultaneously buying one call option and selling another call option at a different strike price in the same underlying, with the same expiration. Likewise, a put vertical involves simultaneously buying a put option and selling another put option at a different strike price in the same underlying, with the same expiration.
Among call and put vertical spreads, there are two types: credit and debit. To create a credit spread, traders sell an option with a high premium and buy an option with a low premium. To form a debit spread, traders purchase a high premium option and sell an option with a low premium.
The Credit Spread
The risk in a vertical credit spread is determined by the difference between its strikes minus the credit received, plus transaction costs. The maximum potential profit for a vertical credit spread is the premium collected when selling the spread, minus transaction costs. For example, if a trader sells an XYZ 102/104 call vertical for $0.60, the risk is $140 per contract and the maximum potential profit is $60 per contract, minus transaction costs. See figure 1.
Vertical credit spread characteristics:
- Risk per contract = (Difference between the strikes – credit received) x 100, plus transaction costsMax profit per contract = Credit received x 100, minus transaction costs
For the XYZ example:
- Risk = $140, or ($2.00 – $0.60) x 100, plus transaction costsBreakeven level = $102.60, or $102 (the short strike) + $0.60 (credit received)Max potential profit = $60 ($0.60 x 100), minus transaction costs
FIGURE 1: VERTICAL CREDIT SPREAD PROFIT AND LOSS.
This profit and loss graph shows max loss, breakeven, and max profit for an XYZ 102/104 credit spread. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
The Debit Spread
When buying a vertical debit spread, the risk is the premium paid for the spread. The maximum profit is determined by subtracting the premium paid from the spread between strike prices, minus transaction costs. For example, if a trader buys a FAHN 210/207 put vertical for $1.20, the risk is $120 per contract plus transaction costs and the maximum potential profit is $180, minus transaction costs. See figure 2.
Vertical debit spread characteristics:
- Risk per contract = Amount paid for the spread x 100, plus transaction costsMax profit per contract = (Difference between the strikes – amount paid for spread) x 100, minus transaction costs
For the FAHN example:
- Risk = $120 ($1.20 x 100), plus transaction costsBreakeven level = $208.80, $210 (long strike) – $1.20 (the debit paid for the spread)Max potential profit = $180, or ($3.00 – $1.20) x 100, minus transaction costs
FIGURE 2: VERTICAL DEBIT SPREAD PROFIT AND LOSS.
This profit and loss graph shows max loss, breakeven, and max profit for a FAHN 210/207 debit spread. Data source: CBOE. Chart source: the TD Ameritrade thinkorswim® platform. For illustrative purposes only. Past performance does not guarantee future results.
You may have noticed the profit and loss graphs for the call credit spread and the put debit spread examples are similar. This is because they are both bearish, risk-defined spreads.
Now that you understand the basic characteristics of vertical spreads, let’s talk about their versatility. The vertical spread is a directional play that enables an options trader to express a bullish or bearish view. It can also be used to take advantage of relatively high or low volatility levels.
Let’s say an options trader thinks a stock is oversold and volatility levels are due to decrease. In this case, selling an out-of-the-money vertical put credit spread might be appropriate. Selling a vertical put credit spread is a bullish strategy that seeks to profit from a rise in the price of the underlying as well as a decrease in volatility.
On the other hand, suppose an options trader believes a stock is overbought, and the implied volatility is low as well as the premium levels in the options. This might be a good time to buy an at-the-money vertical put debit spread. This is a bearish strategy that seeks to profit from a fall in the price of the underlying as well as an increase in volatility.
These are just a few of the ways that vertical spreads can be used to place directional trades on an underlying stock in a risk-defined manner. Next time you believe an underlying is poised to make a move, consider using a vertical spread to potentially capitalize on your idea.
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