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Vertical Spread

A vertical spread is a basic defined risk strategy that’s made up of a short option at one strike and a long option at a different strike in the same expiration cycle. Vertical spreads can be placed by using two different call options or two different put options and there are four different ways to place a vertical spread. A vertical spread can be traded by setting up a short call spread, long call spread, short put spread, or a long put spread. Short or long simply refers to the action being taken regarding the strike closest to the current price of the underlying stock. With a short call or put spread, we are selling the call/put closest to the underlying’s price and then buying a call/put further away. With a long call or put spread, we are buying the call/put closest to the underlying’s price and then selling a call/put further away. Long vertical call/put spreads are debit strategies, meaning we are buying the spread, while short vertical call/put spreads are credit strategies, meaning we are selling the spread.

Regardless of the type of vertical spread being placed, the spread has defined risk. With a long call/put spread, the most that can be lost is the debit paid to buy the spread. For a short call/put spread, the maximum possible loss is the difference between the width of the spread and the credit received for selling the spread. Ex) Selling a 1 point wide spread for a credit of $0.30 results in a max possible loss of $0.70 (1.00 - 0.30 = 0.70).

Short Vertical Call Spread

Fig. 1

 A short vertical call spread is a defined risk strategy that can be used when we have a bearish assumption on the price of an underlying stock (we think the price of the underlying will decrease).  This is also known as a credit spread. In figure 1 we have a short vertical call spread created by selling the 210.5 strike and buying the 212.5 strike. The short 210.5 spread is trading for $0.60 and the long 212.5 call is trading for $0.27. Therefore, if we sell the spread with the options at these prices, we would receive a credit equal to the difference of the price of the option we are selling and the price of the option we are buying ($0.60 - $0.27 = $0.33). This translates into a credit of $33. Since we’re selling this spread, the most we can make on the trade is the credit of $33 and the most we can lose is $177, the difference between the width of the spread and the credit received (200 - 33 = $177). Additionally, as we are selling the call option closest to the current price of the underlying, this strategy profits from a decrease in the price of the underlying and loses money if the price of the underlying increases (indicated by the green profit zone and red loss zone). Should the price of the underlying be below both the short and long strikes at expiration, this spread will expire worthless and we will keep the entire $33 credit we initially received for selling the spread. This is the ideal outcome when placing this trade. If the price of the underlying is between the short and long strikes at expiration, we have the obligation to sell 100 shares of the underlying at the price of the short strike 210.5. Finally, if the price of the underlying is above both the short and long strikes, this trade will realize its max possible loss of $177.

 

Long Vertical Call Spread

Fig 2. 

Now let’s take a look at a long vertical call spread. This is the opposite of the short vertical call spread. A long vertical call spread is a defined risk strategy that can be used when we have a bullish assumption on the price of an underlying stock (we think the price of the underlying will increase). A long vertical call spread is a debit spread. Since debit spreads have a lower probability of profit, this spread has been set up to get close to a 50% probability of profit by buying a call one strike in-the-money and selling a second call out of the money. Figure 2 displays a two point wide long vertical call spread that’s created by purchasing the 207 call and selling the 209 call. The cost of the spread is the difference between the price of the option we are buying and the price of the option we are selling ($2.05 - $1.06 = $0.99). The debit we are paying for this spread is the most we can possibly lose. While the cost of the spread is the max possible loss, the max potential profit is found by taking the width of the spread and subtracting the debit paid ($200 - $99 = $101). For this trade to reach max profit, the price of the underlying needs to be above the strike prices of both the long and short calls at expiration (indicated by the green profit zone). If the price of the underlying is below the strikes for both the long and short call, the spread will expire worthless and we will lose the initial debit that we paid for the trade. If the price of the underlying is between the long and short strike at expiration, the short call will expire worthless, but the long call will have some intrinsic value. We can then sell to close the long call or exercise the long call option and purchase 100 shares of the underlying at the strike price of 207, should we choose to do so.

 

Short Vertical Put Spread

Fig 3.

 A short vertical put spread is a defined risk strategy that can be used when we have a bullish assumption on the price of an underlying stock (we think the price of the underlying will increase). This spread is created by selling a put option and buying a second put option at a different strike. One put option is sold at a strike below the current price of the underlying and a second put option is purchased at a strike further below the price of the underlying. Since we are selling the spread, we receive a credit for the trade and the credit received is the difference between the price of the option being sold and the price of the option being purchased. In figure 3, a short vertical put spread has been created by selling the 202 put and buying the 199 put. The 202 put is trading for $1.06 and the the 199 put is trading for $0.68, so the credit received if we were to sell the spread with the options at these prices is $38 ($1.06 - $0.68). The credit received for selling the spread is the max possible profit for the trade. A short vertical put spread is a defined risk trade, so the max loss is once again determined by taking the difference between the width of the spread and the credit received. In this example the spread is three points wide, so the max loss is $300 - $38 = $262. This type of trade is bullish and the trades will realize max profit if the price of the underlying is above the strike price of the short put. If the price of the underlying is between the strikes of the short and long puts at expiration, we have the obligation to buy 100 shares of the underlying at the price of the short put. If the price of the underlying is below both the strike prices of the short and long puts, this trade will realize its max loss.

 

Long Vertical Put Spread

Fig. 4

 A long vertical put spread is the opposite of a short vertical put spread and is a defined risk strategy that can be used when we have a bearish assumption on the price of an underlying stock (we think the price of the underlying will decrease). A long vertical put spread is a debit spread. Since debit spreads have a lower probability of profit, this spread has been set up to get close to a 50% probability of profit by buying a put option one strike in-the-money and selling a second put option at a strike out-the-money. Figure 4 displays a two point wide long vertical put spread that’s created by purchasing the 207.5 put and selling the 205.5 put. The cost of the spread is the difference between the price of the option we are buying and the price of the option we are selling ($2.88 - $1.99 = $0.89). The debit we are paying for this spread is the most we can possibly lose. While the cost of the spread is the max possible loss, the max potential profit is found by taking the width of the spread and subtracting the debit paid ($200 - $89 = $111). The long vertical put spread profits from a decrease in the price of the underlying and loses money if the price of the underlying increases (indicated by the green profit zone and red loss zone). Should the price of the underlying be below both the long and short strikes at expiration, this spread will realize max profit. This is the ideal outcome when placing this trade. If the price of the underlying is above the strike prices of both the short and long strikes at expiration, this trade will realize max loss (the debit paid for the spread). If the price of the underlying is between both the long and short strikes at expiration, the short put will expire worthless and the long put will have some intrinsic value. We can either sell the long put option for a credit or chose to exercise the option, giving us the right to sell 100 shares of the underlying at the strike price of the long put.

 

Once you have chosen a market direction you can pick your vertical spread!  

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