Vertical Spread Types and Uses
It’s important to understand what a vertical spread is, the types of vertical spreads, and when each type of vertical spread is appropriate to use. This knowledge allows investors to learn how to effectively use each in real-life trading.
- There are four types of basic vertical spreads that include the bull call, the bear call, the bull put, and the bear put.
- Vertical spreads are used by traders when they’re trying to determine the movement in the price of an asset.
- Using a vertical spread in conjunction with other trading strategies is a great way to build the profitability of your investments.
- Traders typically use a vertical spread when they’re expecting a moderate move in the price of one of their underlying assets.
What Does Vertical Spread Mean in Trading?
Simply put, a vertical spread involves buying and selling options of the same type simultaneously. Whether you’re selling puts or calls, the strike prices will be different. A tip is to think of the term vertical here to mean the position of the strike prices. There are four types of basic vertical spreads, including the bull call, bear call, bull put, and bear put. Each one has a different execution technique.
Vertical spreads are useful when trying to determine the movement in the price of an asset. They’re directional plays, for the most part, and can be tailored to reflect your specific views, whether they be bullish or bearish, on the underlying assets. Depending on the type of vertical spread that’s used, the trader’s account will be credited or debited.
Each type of vertical spread involves buying and writing a put or a call at different stock prices. Vertical spread offers two legs, with buying being one option and writing being the other option. This can result in either a credit or debit. A debit spread is going to result in the put costing money.
When Should a Vertical Spread Be Used?
Traders typically use a vertical spread when they’re expecting a moderate move in the price of one of their underlying assets. A vertical spread is typically used for two reasons:
- To reduce the premium amount that is payable for debit spreads.
- To lower the risk of the options position for credit spreads.
A vertical spread involves the sale of options where the proceeds should at least partially, if not fully, help to offset the required premium to purchase another leg, such as buying the option. As a result, they’ll experience a lower-cost trade with lower risk. In return for that lower risk, this trading strategy is capped at profit potential.
If you’re expecting a substantial move in the price of one of your assets, a vertical spread would not be appropriate.
Types of Vertical Spreads
There are several different types of vertical spreads. Looking at the aspects of each of these types of vertical spreads will provide a better picture of what options you have.
- A bull call spread is a debit spread where the maximum loss is restricted to the net premium that was paid for the position. A bull call spread is when you purchase one call option and simultaneously sell another with a matching expiration date, but with a higher strike price. The maximum profit in this strategy is the same as the difference in the strike price of the call minus the net premium that was paid to put on the position.
- A bear call spread is a credit spread where your maximum gain will be restricted to the net premium that was received for the position. The maximum loss in this strategy is the same as the difference in the strike prices of the calls minus the net premium that was received. The bear call spread is when you sell a call option while simultaneously purchasing another with the same date of expiration but a higher strike price.
- A bull put spread is another type of credit spread. In this case, it’s writing a put option while simultaneously purchasing another with the same expiration date and lower strike price.
- A bear put spread is a type of debit spread. This scenario takes place when you purchase a put option while simultaneously selling another with a lower strike price but the same date of expiration.
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Which Vertical Spread Should You Use?
There are two main reasons that a vertical spread is used. A debit spread is used to reduce the payable premium amount, while a credit spread is used to lower the option position’s risk.
For a debit spread, premiums can be expensive, especially when market volatility is high or when a specific stock has high implied volatility. A vertical spread will cap the maximum gain that can be made from an option position. It also reduces the position’s cost when compared to the profit potential of a stand-alone call or put scenario.
When it comes to credit spreads, they can be used in a situation where you want to reduce the risk of writing options. Option writers generally take on significant risk for a smaller amount of premium. Just one trade can turn disastrous and wipe out positive results from all other trade options.
Vertical spreads help to mitigate the risk of writing uncovered, or naked, calls. While writing puts is less risky, a trader with numerous written puts would be stuck in a situation where they have a large number of costly stocks in an event of a market crash.
Example of a Vertical Spread
Looking at examples of using different vertical spread options can help you know how and when to use these strategies. In this example, your formula for the breakeven price is equal to the long call’s strike price plus the premium paid. Your maximum profit potential is your spread width minus the premium paid multiplied by $100 (unless your contract multiplier is something other than this). Your maximum loss potential is equal to your premium paid multiplied by $100.
For a bull call spread, imagine an entry stock price of $140.00. Say you have an option to purchase 13 calls for $8.50 and sell 13 calls for $1.20. Both have an expiration date of 45 days.
- Your spread entry price here is $8.50 – $1.20 = $7.30.
- Your breakeven price is $130 + $7.30 = $122.70.
- Your maximum profit potential is ($15 spread width – $7.30 premium paid) ($7.70) multiplied by $100 = $770.
- Your maximum loss potential is $7.30 multiplied by $100 = $730.
Considerations of Vertical Spread
W hile there are many advantages to using a vertical spread, there are some important things to consider as well. The profit potential is limited. Less risk means less reward for the most part, but you shouldn’t let this stop you from using a vertical spread for your trading system.
There are also several advantages to using a vertical spread. Thanks to the versatility of this strategy, you’ll find that it offers a more limited-risk scenario while still being able to be used to collect the premiums. Keep in mind that you can also lose what you have already spent. You should always compare your analysis to current market conditions to determine which vertical spread is best suited for the situation.
Using a vertical spread in conjunction with other trading strategies is a great way to build the profitability of your investments. Learning about the types and uses of each provides some valuable insight into the world of vertical spreads and trading. Knowing which option to use and when to use it will greatly help your odds of profiting in a trading situation.