Vertical Spreads: A Primer

Published on: Feb 26 2015 by John Critchley

Vertical Spreads: A Primer

 

By: John Critchley- SogoTrade Option Principal & Senior Option Specialist

 

Option Spreads. Sounds esoteric and scary to many of the uninitiated, but basic option spreads are really quite simple and easy to understand.  Here is a primer on the most basic of option spreads, the Vertical Spread.

 

 

What is a Vertical Spread?

Vertical spreads, a strategy done with either calls or puts, involve buying one option and selling another option of the same type and expiration, but a different strike price.

 

A bull call spread consists of buying one call and selling a higher-strike, lower-priced call to offset a portion of the premium cost. This type of spread would be done for a debit.

 

 A bear call spread consists selling the lower-strike call and buying a higher-strike call to hedge the risk. This would produce a credit in your account and there is a margin requirement that is held for these types of positions.

 

A bear put spread consists of  buying one put and selling a lower-strike, lower priced put to offset a portion of the premium cost. This type of spread would be done for a debit.

 

 A bull put spread consists selling the higher-strike put and buying a lower-strike, lower priced put to hedge the risk. This would produce a credit in your account and there is a margin requirement that is held for these types of positions.

 

 

The debit vertical spreads (bull call and bear put spreads) will normally profit from a sharp directional move. The position will profit if the stock has moved past the bought strike plus the debit paid. For the maximum profit, the underlying needs to move to or beyond the sold strike by expiration. For example, if the AAPL  march 130/135 call spread is bought $2.00, then the full profit will come with the underlying at or above above 135 and the position will profit anywhere above $132.   Long Vertical spreads lose if the underlying moves against the directional bias of the spread. The maximum loss for debit spreads is the debit paid. Debit vertical spreads are normally used to offset the cost of the purchased option. This is especially true when implied volatilities are high.

 

 

Credit vertical spreads involving calls reach maximum profit if the underlying is below the short strike at expiration. The break-even for the spread is this strike plus the credit.

 

 

Credit vertical spreads using puts reach maximum profit if the underlying is above the short strike at expiration. The break-even for the spread is this strike minus the credit.

 

Credit spreads are normally used when one wants to be a net seller of options, but wants to limit the potential losses. Option selling can have a very high probability of profit, but also the potential for large losses, and using a credit spread limits that exposure.

 

For example, if the AAPL April 125/130 call spread is sold for $2.70, and then the maximum profit will be realized with AAPL at or below $125 at expiration. The maximum loss is the difference in strike prices ($5) minus – the premium or credit received ($2.70).

 

 

In Conclusion:

 

Vertical spreads provide quantifiable maximum gains and losses.

They are normally in underlyings with high implied volatility readings and high premiums.

They can be credit or debit spreads.

They increase the probability of profit with directional trades, but limit the upside.

 

Learn more about spreads on the SogoTrade Education page:  http://www.sogotrade.com/education/OptionBasic1.aspx

Stay tuned…

 

Disclaimer


We are not liable for any trading decisions made by any reader. NO advice is given or implied. The information offered in  this article is for demonstration purposes ONLY and should not to be either construed as an offer or considered to be a recommendation to buy or sell any options .

Your use of this information is entirely at your own risk. It is your sole responsibility to evaluate the accuracy, completeness and usefulness of the information. You must assess the risk of any trade with a professional broker, or financial planner, and make your own independent decisions regarding any trades mentioned herein. This is not a solicitation to buy or sell any options, or to purchase or sell any credit spreads. Trading options only carries a high degree of risk, is not suitable for all traders/investors, and you may lose all of your premium money invested in the options. If you have never traded options before, we strongly recommend that you read a little background information made available by the government. Only you can determine what level of risk is appropriate for you. Also, prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options.

Past performances DO NOT guarantee future results. Please consult with your own independent tax, business and financial advisors with respect to any trade. We will NOT be responsible for the consequences of anyone acting on this purely demonstration material.

 

 

 

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