Spread Option Strategies: The Vertical Spread Option
You certainly already understand the concept or how it works rather than buying a call and put options, which is enough with that understanding for you to start trading options.
However, suppose you also understand trading strategies in options trading.
It will help you as an options trader to determine the amount of reasonable risk and see trading opportunities that you might not have found before.
The option has various types of strategies that every trader can apply.
But there is a very powerful options strategy to use when you trade options.
And if you manage to understand this strategy, you will be able to develop even further as an options trader.
Yes, it is a vertical spread option; what kind of strategy is that?
Read the article to the end to understand this best option strategy.
- What is Vertical Spread Option
- Vertical Spread Type
- Which Type of Vertical Spread the Best to Use?
- Example Vertical Spread Strategy
- Factors to Consider In Using This Strategy
- Advantages of Vertical Spread Strategy
What Is Vertical Spread Option?
A vertical spread is a type of trading strategy in which the trader uses a vertical spread to make a profit in which two options are traded simultaneously.
It is the most basic option.
A combination of a long option and a short option at different strike prices.
The strike price is the price at which the option holder can exercise the option to buy or sell an underlying security, depending on whether they have a call option holds or not put option.
An option is a contract with the right to exercise the contract at a specified price, known as the strike price.
The trade is collectively known as a vertical spread, albeit with the same expiry or maturity dates.
Why is it called a vertical spread?
Actually, this is because of the habit of displaying the options table.
The options table shows the month horizontally, and the strike price is displayed vertically.
Then because this spread has a different strike price, it is called a vertical spread.
Each vertical spread involves buying and writing a put or call with a different strike price.
Each spread has two legs, where one leg buys the option, and the other leg writes the option.
It can result in an option position (containing two legs), providing a credit or debit to the trader.
A debit spread is when making a trade costs money.
For example, one option costs $600, but the trader receives $200 from another position.
The net premium charge is a $400 debit.
If the situation is reversed, the trader receives $600 to trade the option, and the other option costs $200; the two options contracts are combined for a net credit premium of $400.
Types of Vertical Spread Option
Vertical spreads can be credit or debit.
If we buy an Option and then sell another Option of a similar type and expiration date, we enter a vertical credit spread.
This means you can keep a portion of your investment if things don’t go your way.
You will only lose what you paid for trading fees such as brokerage fees, commissions, and bid-ask spreads.
A vertical debit spread is created by selling one option and buying another at a higher strike price.
The maximum loss in a debit spread equals your initial investment (credit) plus any additional costs incurred when executing the trade (commission).
The minimum profit has no predetermined value as it varies with volatility and time to expiration.
There are four types of Vertical Spread that you can apply in your trading; what are they?
Bull Vertical Call Spread
To help pay for the cost, this strategy involves buying one call option and selling another at a higher strike price.
Spreads are generally profitable if the stock price moves higher, as is the case with a typical long call strategy, to the point where a short call limits further gains.
This strategy’s potential gains and losses are very limited and well defined: the net premium paid upfront sets the maximum risk, and the short call strike price sets the upper bound at which further stock gains will not increase profits profitability.
The maximum profit is limited to the difference between the strike price and the debit paid for placing the position.
The maximum loss on a fixed spread position is limited to premium spending as long as, and only as long as the integrity of the spread is maintained.
If the investor trades out or makes a low-strike call, the maximum loss is no longer limited to premium spending.
Bear Vertical Call Spread
The Bear Call Spread strategy involves buying a Call Option while selling a Call Option at a lower strike price on the same underlying asset and expiration date.
You receive a premium for selling Call Options and pay a premium for buying Call Options.
So your investment cost is much lower. The strategy is less risky, with rewards limited to the difference in premiums received and paid.
When a trader believes there is a good chance of making a profit, he or she will use this strategy and the underlying asset’s price will fall moderately.
This strategy is known as a bear call credit spread because net credit is received when entering a trade.
The maximum loss on a bear call spread is limited and only as long as the spread’s integrity is maintained.
If an investor makes a trade or makes a high-strike call, the maximum loss is no longer limited. There are additional risks associated with expiration weekends.
If a short call is set while a long is not (executed, for example, the stock finishes between two strikes), the investor has a short position in the stock.
The good news over the weekend could force bigger losses on the investor before he can exit a short equity position.
Bull Vertical Put Spread
The bull put spread and an options strategy is used by an investor when he believes the underlying stock will show a moderate increase in price.
Buying an out-of-the-money (OTM) put option and selling an in-the-money (ITM) put option with the same underlying asset and the expiration date is referred to as a bull put spread.
Bull put spreads should only be used when the market shows an uptrend.
Bear Vertical Put Spread
One long put with a higher strike price and one short put with a lower strike price make up a bear put spread. The underlying stock and expiration date are the same for both puts.
A bear put spread is set for the net debit (or net charge) and profit when the underlying stock price falls.
Profits are limited if the stock price falls below the strike price of the short put lower strike, and the potential loss is limited if the stock price rises above the long put’s strike price (higher strike).
Which Type Of Vertical Spread The Best To Use?
When calls are expensive due to high volatility and you expect moderate gains rather than large gains, consider using a bull call spread.
This scenario is usually seen in the last stages of a bull market when the stock is nearing its peak and profits are more difficult to achieve.
Bull call spreads can also be effective for stocks with great long-term potential but are highly volatile due to recent declines.
Consider using bear call spreads when volatility is high and moderate downside forecasts.
This scenario is usually seen in the late stages of a bear market or correction when the stock is approaching a trough, but volatility increases as pessimism reigns.
When the market is choppy, consider using a bull put spread to earn a premium on a slightly higher market or to buy a stock at a lower price.
Buying the stock at a lower price is possible because a written put can be made to buy the stock at the strike price, but because credit has been received, it reduces the cost of buying the stock (compared to if the stock was purchased at the strike price outright).
This strategy is perfect for accumulating high-quality stocks at low prices when sudden volatility occurs, but the underlying trend is still rising.
A bull put spread is similar to “Buy the Dips,” with the bonus of receiving premium earnings.
When a stock or index is expected to decline moderately to significantly and volatility is rising, consider using a bear put spread.
Bear put spreads can also be used to reduce the dollar amount of the premium paid during periods of low volatility, such as when protecting long positions after a strong bull market.
Vertical Spread Strategy Example
A bull vertical call spread can be used by an investor who wants to bet on a stock moving higher.
The investor purchases a call option on the stock of Company XYZ, which is currently trading at $100 per share.
The investor purchases an in-the-money (ITM) option with a strike price of $90 for $8 and sells an out-of-the-money (OTM) call with a strike price of $110 for $6.
At expiration, Company XYZ’s stock trades at $98. In this situation, the investor would use their call option, paying $90 and then selling for $98, netting an $8 profit. The call they sold expires worthless.
The $8 profit from the stock sale, plus the $6 premium and less the $8 premium paid, leaves a net profit of $6 for the spread.
Factors To Consider In Using This Strategy
The following factors can help in coming up with an appropriate deployment option/strategy for your current conditions and outlook.
Bullish Or Bearish
Is your market positive or negative?
If you are very bullish, you might be better off considering stand-alone calls (not spreads).
But if you expect modest gains, consider a bull call spread or a bull put spread.
Likewise, if you are somewhat bearish or want to reduce the cost of hedging your long positions, a bear call spread or bear put spread may be the answer.
Do you expect volatility to go up or down?
The increased volatility can benefit option buyers who favor a debit spread strategy.
Decreasing volatility increases opportunities for option writers who support a credit spread strategy.
Risk Reward Ratio
If your preference is limited risk with more significant potential for reward, it’s more of an options buyer mentality.
If you are looking for a little reward for possibly greater risk, this is more in line with the options writer mentality.
Based on the above, if you are somewhat bearish, think volatility is on the rise, and prefer to limit your risk, the best strategy is to use a bearish spread.
On the other hand, if you are moderately bullish, think volatility is falling, and are comfortable with the outcome of writing options, you should opt for a bull put spread.
Advantages Of Vertical Spread Strategy
When using a vertical spread strategy, your trade will involve the same amount of credit and debit at the time of execution.
Since trading consists of no transaction fees, you can take unlimited risks.
You can even adjust the maximum reward to achieve the desired result. In the end, you’ll get the best of both worlds.
A good rule of thumb is always to set a maximum reward of 25% of the total equity value of your stock portfolio.
The main advantage of the vertical spread strategy is that it allows you to reduce your overall trading costs, but this strategy has its limitations.
If the stock price breaks sharply, you may not want to trade the stock using a vertical spread. But if you can get the price up quickly, you might want to consider this strategy.
It’s an easy way to get started in the stock market and is accessible via an online trading platform.
Professional traders mostly use vertical spread options, which are advanced derivative contracts.
If a retail trader does not fully comprehend how this strategy works, he should not use it. It can cause irreparable harm if misused. So, traders should be cautious while using this strategy.
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