Introduction to Vertical Spreads

A vertical spread is an option strategy which is an option buy and an option sale with both options having the same expiry month. This strategy can be executed with either calls or puts and is known as a directional strategy of trading. If you executed a vertical spread on a call option you would be bullish about the underlying asset (bull call spread), and if you executed a put vertical spread you would be bearish about the underlying asset. (Bear put spread).

It is a much more flexible transaction for the trader to execute a vertical spread than to execute a plain vanilla transaction.

Let’s look at a typical strategy.

ABC shares are trading around $60.05 and you believe that the shares will rise. A $57 June call will cost you $5.50. You buy the call currency options trading and pay the $5.50 premium which will be your total risk. You can reduce that risk by selling a call that is near where you feel the price of the ABC shares will rise to. So you sell a $68 call and receive the premium of $1.05. You have now reduced your risk from $5.50 to $4.45.

There is a price you must pay for reducing your risk and that is that you have effectively capped your profit. The most you can make with your vertical spread is the difference between the strike prices of $57 and $68, at the most $11. If at expiry ABC shares were indeed at $68 your overall profit would be $6.55 ($11 less $4.45 risk). To make any money on this deal as you paid a net premium of $4.45 ABC shares must be at least $61.45 which is only a movement of $1.40 from the current trading price of $60.05.

Let’s now look at a vertical spread that is already in the money. We will still buy our ABC $57 call at $5.50 but this time we will sell a $58.70 call at $4.40. The cost for our vertical spread is $1.10 ($5.50-$4.40). The gap between $57 and $58.70 is $1.70 so we have a potential profit of $0.60 ($1.70-$1.10). Not much profit but with ABC shares trading at around $60.05 beyond the short option by $1.35, ABC shares don’t have to move at all for the position to be profitable.