Vertical Spread in Options Trading

Understanding Vertical Spreads

Vertical spreads are an ingenious strategy used in options trading. Picture it as a strategic chess move in the financial markets, designed to cap both potential gains and losses. A vertical spread involves the simultaneous purchase and sale of two options of the same type (either two call options or two put options), but with differing strike prices.

In this guide, we will explore the depth of vertical option trading, including potential profits and loss calculation, to help you navigate the derivatives market successfully.

Key Takeaways

• Vertical spread entails the simultaneous execution of two contracts of the same type (call/put), sharing an identical maturity date, but distinct exercise prices.
• The strategy comes in two variants: bullish and bearish vertical spreads.
• In order to calculate the potential profits or losses from this strategy, one must take into account the strike prices, the net premium accrued, and the asset's price upon reaching maturity.
• Decisions on closing or adjusting the strategy significantly impact the ultimate profitability and degree of risk.
• Credit spreads denote an initial inflow of cash, whereas debit spreads call for an upfront outlay of capital.

What Is a Vertical Option Spread?

In a vertical spread, two option contracts sharing a common expiration date, but distinct strike prices, are executed concurrently. These contracts should be of the same type (either calls or puts). The ultimate goal here is to reduce the risk inherent in holding a single derivative. As such, the second contract (that is purchased) operates as a financial cushion, offsetting the cost of the first (that is sold).

The name “vertical” stems from the arrangement of the option chains. Below, you can observe an example of a value chain with contracts for Bitcoin. The exercise prices, illustrated in the far right column, descend vertically.

Upon deploying a vertical spread, you navigate this matrix from 'top-to-bottom'. That is, you are picking two matching options (either calls or two puts) that align vertically, distinguished solely by their strike prices.

At its core, this approach limits both potential profits and potential losses. That is why it may render a cost-effective choice for traders with precise predictions concerning the closing value of the base asset.

Now, that we have vertical spreads explained, let’s proceed to the types of the strategy.

Types of Vertical Spreads

Bullish Vertical Spreads

Bullish vertical option combinations are used by market participants who anticipate an upsurge in the value of the base asset. They are implemented through two strategies:

• The long call vertical spread
• The short put vertical spread

Bearish Vertical Spreads

On the flip side, bearish vertical option combinations predict a drop in the value of the base asset. There are two primary strategies that work under this market assumption:

• The short call vertical spread
• The long put vertical spread

Vertical Spread Strategies and Examples

Long Call Vertical Spread

Definition

A long call vertical spread, also known as a bull call spread, is implemented when a market participant believes the value of the base asset will rise moderately. You can learn more about bull call spread from our article. In short, this strategy includes the following actions:

• buying a call option
• selling another call contract with a higher exercise price

For this and the following strategies, both derivatives should be on the same asset and have the same expiry date.

Profit/Loss Chart

The profit and loss chart for a long call vertical spread shows a pinnacle profit when the value of the base asset is at or above the higher exercise price at maturity. The max loss occurs when the asset's price is at or below the lower exercise price at maturity. Breakeven points, in this case, are calculated as follows:

• Upper break-even point = net premium expenditure + the exercise price of the long call contract.
• Lower break-even point: there is no lower break-even point since the max loss is limited to the net premium expenditure.
  

Long Put Vertical Spread

Definition

A long put vertical spread, also known as a bear put spread, is a technique employed when a trader anticipates a moderate decrease in the value of the base asset. This strategy includes the following components:

• purchasing a put option
• selling another put contract with a lower exercise price

Profit/Loss Chart

The profit/loss graph of a long put vertical spread showcases a max gain when the value of the base asset is at or below the lower exercise price at maturity. Conversely, the max loss is incurred when the asset's price is at or above the higher exercise price at maturity. Breakeven points for this spread are calculated as follows:

• Upper break-even point: there is no upper break-even point, since the max loss is limited to the net premium expenditure.
• Lower break-even point = the exercise price of the long put – the premium expenditure.
  

Short Call Vertical Spread

Definition

A short call vertical spread, otherwise referred to as a bear call spread, is employed when an investor foresees a moderate decrease in the value of the base asset or anticipates the price will remain stable. This strategy includes:

• selling a call option
• buying another call contract with a higher strike

Profit/Loss Chart

The profit and loss diagram for a short call vertical spread indicates a max gain when the value of the base asset is at or below the lower exercise price at maturity. On the other hand, the max loss occurs when the asset's price is at or above the higher exercise price at maturity. Breakeven points in this case are calculated as follows:

• Upper break-even point = the net premium earned + the exercise price of the short call.
• Lower break-even point: there is no lower break-even point, since the max loss is theoretically unlimited (if the value of the base asset rises significantly).
  

Short Put Vertical Spread

Definition

A short put vertical spread, also known as a bull put spread, is a technique that investors employ when they expect a moderate increase in the value of the base asset. Here is the breakdown of the strategy:

• selling a put option
• buying another put contract with a lower exercise price

Profit/Loss Chart

The profit/loss diagram for a short put vertical spread reveals a max gain when the value of the base asset is at or above the higher exercise price at maturity. Conversely, the max loss is sustained when the asset's price is at or below the lower exercise price at maturity. Breakeven points calculations:

• Upper break-even point: there is no upper break-even point, since the max loss is theoretically unlimited (if the value of the base asset falls significantly).
• Lower break-even point = the exercise price of the short put – the net premium earned.
  

Calculating Vertical Spread Profit and Loss

The analysis of the profit and loss for the strategy encompasses factors such as the premium earned or paid, the exercise prices at play, and the number of contracts in the trade. It is worth noting that the profit and loss potential of this strategy fluctuates, depending on whether it takes a form of a debit spread (involving a spread purchase) or a credit spread (involving a spread sale).

For Debit Spreads:

• The max loss = debit paid to initiate the trade.

The loss occurs if the value of the base asset is below the lower exercise price (for a call spread) or above the higher exercise price (for a put spread) at expiry.

• The max profit = the distinction between the strikes – the debit paid.

It is realized if the value of the base asset is above the higher exercise price (for a call spread) or below the lower exercise price (for a put spread) at expiry.

For Credit Spreads:

• The max loss = the distinction between the strikes – the net credit received.

It occurs if the value of the base asset is above the higher exercise price (for a call spread) or below the lower exercise price (for a put spread) at expiry.

In order to simplify your work, you can use an online calculator.

• The max profit = the net credit received to initiate the trade.

It occurs if the value of the base asset is below the higher exercise price (for a call spread) or above the lower exercise price (for a put spread) at expiry.

Vertical Spread Break-Even Price

As mentioned earlier, the break-even price for vertical spreads is a crucial consideration for traders. This value denotes the juncture at which the strategy neither gains nor loses money, excluding the transaction costs.

We will have vertical call spread break-even explained. Suppose Bitcoin is currently trading at $20,000.

Buy a call option on Bitcoin with an exercise price of $20,000, which costs $500 (premium). Concurrently, sell a call on Bitcoin with an exercise price of $21,000, which you sell for $300.

Here, you've created a bull call spread for a net cost, or net debit, of $200 ($500 – $300).

Now, to calculate the break-even point. Add the net cost of the spread to the exercise price of the call contract you bought. In this case, the break-even point would be $20,200 ($20,000 strike price + $200 net debit).

So, Bitcoin needs to be at $20,200 at expiry for this trade to break even, excluding any transaction costs. If it is above this level, the trade would be profitable. If it is below this level, the trade would incur a loss, up to a max loss of the net cost of the spread ($200).

Real-World Example of a Bull Vertical Spread

Let’s say that Bitcoin is currently trading at $20,000. An investor has a bullish sentiment and decides to implement a long call vertical spread. The trader buys a call option with an exercise price of $21,000 and sells another call with an exercise price of $23,000. Both contracts expire in a month. The $21,000 call costs $500 (premium), and the $23,000 call can be sold for a premium of $200. The total cost of setting up this spread is therefore $300, which is also the max possible loss.

As the price of Bitcoin moves above $21,000, the long call option starts to make a profit. If, by expiry, Bitcoin rises above $23,000, both contracts are in the money. However, the profit from the $21,000 call is offset by the loss from the $23,000 call. Therefore, the max gain in this setup is the distinction between the two exercise prices minus the net premium expenditure, which equals:

$23,000 – $21,000 – $300 = $1,700

If Bitcoin's price remains below $21,000, both contracts expire worthless, and the investor loses the premium expenditure of $300.

Vertical Spread Technique And Other Strategies

Diagonal vs. Vertical Spread

Similarly to a vertical spread, a diagonal spread also includes one short and one long option positions. However, there is a distinction between them. In a diagonal spread, two contracts have different exercise prices and distinct expiry dates. This strategy is a blend of vertical and horizontal (calendar) spreads, offering both price and time diversification.

Iron Condor vs. Vertical Spread

An iron condor is an advanced technique that involves a combination of bull and bear spreads. Specifically, it involves selling a put and a call (creating a short put spread and a short call spread) while also buying a further out-of-the-money put and call to limit potential losses.

So, in essence, an Iron Condor is a more complex strategy incorporating two vertical spreads, suitable for range-bound scenarios, while a vertical spread is a simpler, directional strategy.

Learn more about iron condor from our in-depth article “Iron Condor Options Strategy: A Comprehensive Guide"

Vertical Spreads at expiry

The strategy allows market participants to capitalize on their market outlook, be it bullish or bearish, with a defined risk and reward. But what happens at expiry greatly depends on the moneyness of the options.

Credit Spreads

In the case of credit spreads, the market participants capitalize on net premiums (or credits) during position initiation. These spreads include strategies like short put vertical option combination (bullish put spread) and short call combination (bearish call spread). The primary objective for both contracts is to expire worthless, allowing traders to retain the full credit received.

For instance, with a short call vertical spread, if Bitcoin remains below the lower exercise price at maturity, both calls expire worthless, enabling the trader to retain the entire premium received at spread initiation. However, if Bitcoin surpasses the higher exercise price, the trader assumes responsibility for the disparity between the exercise prices, offset by the premium initially received.

You can find out more about credit spreads from our article.

Debit Spreads

In the case of Debit Spreads, the trader pays a net premium (or debit) to open the position. These spreads include the long call vertical (bull call) spread and long put vertical (bear put) spread. The market participant hopes the value of the base asset, such as Bitcoin, will move favorably enough to more than cover the cost of the premium expenditure.

Let’s take a long call vertical spread for example. If Bitcoin moves above the higher exercise price at maturity, the spread reaches its max value, which is the distinct between the exercise prices. The trader's profit is this max value less the initial premium expenditure. However, if Bitcoin stays below the lower exercise price, both contracts expire worthless, and the market participant loses the entire premium expenditure to initiate the spread.

Rolling a Vertical Spread

Rolling a vertical spread implies closing the current spread before expiry and concurrently opening a new one with a later expiry date. It's a way to extend the time frame for the trade if the base asset hasn't moved as anticipated.

When to Close and When to Manage Vertical Spreads

Closing

An open position by strategy can be closed anytime before expiry by doing the opposite trade that was done to open the position. For debit spreads, if the base asset's price has moved significantly in the anticipated direction, and you've made a substantial profit, it might be a good idea to close the position early. Thus, you will lock in the gains and avoid potential reversals. For credit spreads, traders often choose to close the position early when a substantial portion of the max possible profit has been realized.

Managing Credit Spreads

Active strategy management is a crucial aspect of trading, includes the following features:

• Tracking market movements: monitor the base asset's price, adjusting or exiting the trade as needed.
• Adjusting positions: “roll” the spread to distinct exercise prices or expiry dates if the trade isn't going as planned.
• Exit strategy: consider closing the trade early if most of the initial credit has already been earned to lock in the profit and reduce risk.
• Balancing profit/risk: aim to let the options expire worthless for max profit, but balance this with risk management.
• Evaluating volatility: keep an eye on market volatility. If volatility rises, consider closing the position to avoid further losses.

Credit Spreads vs. Debit Spreads

In the context of vertical spreads, credit and debit refer to whether you're receiving money (credit) or paying money (debit) when entering the spread.

Credit Spreads

In credit spreads, you receive money upfront by selling a contract and buying another one for protection. Max gain equals the net premium earned, and max loss is limited to the distinction between the exercise prices minus the net premium earned. Short call and short put vertical option combinations are types of credit spreads.

Debit Spreads

Conversely, in debit spreads, you pay money upfront by buying an option and selling another one to reduce the cost. Max gain equals the distinction between the exercise prices minus the net premium expenditure, and max loss is limited to the net premium expenditure. Long call and long put vertical option combinations are types of debit spreads.

Margin and Levels of Options Approval

In options trading, it’s also crucial to consider such essential aspects as margin requirements and levels of options approval.

• Margin Requirements. Margin is the amount of capital required by a broker to cover potential losses in a trade. With options, margin requirements can vary based on the type of trade. For example, selling naked options (options without a corresponding position in the base asset) typically requires substantial margin due to the high risk involved.

• Levels of Options Approval. Brokers, such as Charles Schwab, often require traders to obtain approval to engage in certain types of derivative trades. These approvals are generally divided into levels. The most basic level allows for simple contracts purchases, while higher levels permit more complex strategies like vertical option combinations, and the highest levels allow for selling naked options.

Each level requires the trader to meet certain criteria, including trading experience, risk tolerance, and capital availability. However, it should be noted that the option approval system is practically not used in the cryptocurrency industry.

Advantages of the Vertical Spread

Vertical spreads present an advantageous strategy for a variety of reasons. They offer a defined risk and reward, meaning you know upfront the max amount you could lose or gain. This makes risk management easier and more predictable.

Vertical option combination also requires less capital compared to buying a single option, making them more accessible to smaller accounts. Furthermore, because they involve both buying and selling contracts, they reduce the impact of time decay and changes in implied volatility compared to single-option positions.

FAQs

Should I Let a Vertical Spread Expire?

The decision to let a vertical spread expire or close it before expiry depends on several factors. These factors include the current profit or loss on the trade, the remaining time until expiry, and your expectations for the base asset. For debit spreads, if you've already achieved a significant portion of the max possible profit, you might choose to close the trade early to lock in the gains. For credit spreads, if the contracts are still out-of-the-money as expiry approaches, and you believe they will remain so, you might let them expire worthless and keep the entire premium.

How Can I Make Money Using Vertical Option Combinations?

With vertical option combination, you can make money by correctly predicting the direction (up or down) and extent (how far up or down) of the base asset's price movement. For debit spreads (long call or long put vertical), you make money when the asset's price moves significantly in the anticipated direction. For credit spreads (short call or short put vertical), you make money when the asset's price stays within a certain range.

Are Vertical Spreads Bullish or Bearish?

Vertical spreads display versatility in accommodating both bullish and bearish market expectations. In essence, bullish spreads are tailored for an upward market forecast. Conversely, bearish spreads cater to a market sentiment trending downward.

What Is A Vertical Call Spread

A vertical call spread consists of purchasing of a call and concurrent sale of another call with the same maturity date. Both options are required to have different strikes.

What Is A Vertical Put Spread

A vertical put spread consists of purchasing of a put and simultaneous sale of another put with the same expiry date, but a different strike.

How Does A Vertical Call Spread Work?

There are actually two types of vertical call spreads, the profitability of which will depend on the market trend. Bull vertical call spreads involve purchasing at-the-money or in-the-money calls and selling out-of-the-money calls at a higher strike price. The strategy will generate profit during an upward movement. And vice versa, a bear vertical call spread can be profitable when the prices are falling. Hence, vertical put spreads consist of selling in-the-money calls and buying out-of-the-money calls at a higher strike.

*This communication is intended as strictly informational, and nothing herein constitutes an offer or a recommendation to buy, sell, or retain any specific product, security or investment, or to utilise or refrain from utilising any particular service. The use of the products and services referred to herein may be subject to certain limitations in specific jurisdictions. This communication does not constitute and shall under no circumstances be deemed to constitute investment advice. This communication is not intended to constitute a public offering of securities within the meaning of any applicable legislation.