Why are vertical spreads cheaper?

Since a vertical spread involves both a purchase and a sale, the proceeds from writing an option will partially, or even fully, offset the premium required to purchase the other leg of this strategy, namely buying the option. The result is often a lower cost, lower risk trade than a naked options position.

investopedia.com - What Is a Vertical Spread in Options Trading? - Investopedia

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What Is a Vertical Spread?

A vertical spread involves the simultaneous buying and selling of options of the same type (i.e., either puts or calls) and expiry, but at different strike prices. The term 'vertical' comes from the position of the strike prices. This is in contrast to a horizontal, or calendar spread, which is the simultaneous purchase and sale of the same option type with the same strike price, but with different expiration dates. Key Takeaways A vertical spread is an options strategy that involves buying (selling) a call (put) and simultaneously selling (buying) another call (put) at a different strike price, but with the same expiration. Bull vertical spreads increase in value when the underlying asset rises, while bear vertical spreads profit from a decline in price.

Vertical spreads limit both risk and the potential for return.

1:26 Watch Now: Vertical Option Spreads Explained

Understanding Vertical Spreads

Traders will use a vertical spread when they expect a moderate move in the price of the underlying asset. Vertical spreads are mainly directional plays and can be tailored to reflect the trader's view, bearish or bullish, on the underlying asset. Depending on the type of vertical spread deployed, the trader's account can either be credited or debited. Since a vertical spread involves both a purchase and a sale, the proceeds from writing an option will partially, or even fully, offset the premium required to purchase the other leg of this strategy, namely buying the option. The result is often a lower cost, lower risk trade than a naked options position. However, in return for lower risk, a vertical spread strategy will cap the profit potential as well. If an investor expects a substantial, trend-like move in the price of the underlying asset then a vertical spread is not an appropriate strategy.

Types of Vertical Spreads

There are several varieties of vertical spreads.

Bulls

Bullish traders will use bull call spreads and bull put spreads. For both strategies, the trader buys the option with the lower strike price and sells the options with the higher strike price. Aside from the difference in the option types, the main variation is in the timing of the cash flows. The bull call spread results in a net debit, while the bull put spread results in a net credit at the outset.

Bears

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Bearish traders utilize bear call spreads or bear put spreads. For these strategies, the trader sells the option with the lower strike price and buys the option with the higher strike price. Here, the bear put spread results in a net debit, while the bear call spread results in a net credit to the trader's account.

Calculating Vertical Spread Profit and Loss

All examples do not include commissions.

Bull call spread: (premiums result in a net debit)

Max profit = the spread between the strike prices - net premium paid.

Max loss = net premium paid.

Breakeven point = long call's strike price + net premium paid.

Bear call spread: (premiums result in a net credit)

Max profit = net premium received.

Max loss = the spread between the strike prices - net premium received.

Breakeven point = short call's strike price + net premium received.

Bull put spread: (premiums result in a net credit)

Max profit = net premium received.

Max loss = the spread between the strike prices - net premium received.

Breakeven point = short put's strike price - net premium received.

Bear put spread: (premiums result in a net debit)

Max profit = the spread between the strike prices - net premium paid.

Max loss = net premium paid.

Breakeven point = long put's strike price - net premium paid.

Real-World Example of a Bull Vertical Spread

An investor looking to bet on a stock moving higher may embark on a bull vertical call spread. The investor buys an option on Company ABC, whose stock is trading at $50 per share. The investor buys an in the money (ITM) option with a strike price of $45 for $4 and sells an out of the money (OTM) call with a strike price of $55 for $3. At expiration, Company ABC’s stock trades at $49. In this case, the investor would exercise their call, paying $45 and then selling for $49, netting a $4 profit. The call they sold expires worthless. The $4 profit from the stock sale, plus the $3 premium and less the $4 premium paid, leaves a net profit of $3 for the spread.

investopedia.com - What Is a Vertical Spread in Options Trading? - Investopedia

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