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Options trading can be tricky, but the vertical spread strategy is a way to gain profit while limiting your risks. For investors, vertical spreads offer a balanced way to profit from the market.
You’ll be in a better position to capitalise on market chances and safeguard yourself once you grasp how this strategy works. Keep reading for a closer analysis of vertical spreads in option trading.
What is an option spread?
One way to trade options is to use an options spread, which involves buying and selling many call or put options on a single underlying asset. While these options are similar, they differ in the striking price and the expiration date, or sometimes both.
Options spread strategies may be either vertical, horizontal, or diagonal.
Understanding the vertical spread in option trading strategies
To execute a vertical spread, one must initiate a long (buying) and a short (selling) position in options on an identical underlying asset and expiry date, but at varying strike prices, at the same time. You can’t employ two different option contracts in this directional approach; they must be put or call contracts, respectively.
When two options have varying strike prices, the gap between them is termed the spread width. The word “vertical spread” comes from the fact that the distance between the strike prices is vertical on a typical options chain. A vertical spread’s potential loss and gain are proportional to its width.
For example, the gap between the ₹120 and ₹140 strike prices is ₹20 wide.
Although a vertical spread approach lowers risk, it also restricts the possibility of profit. A vertical spread isn’t suitable for investors anticipating a large, trend-like shift in the underlying asset’s value.
Types of vertical spreads
If a trader thinks the underlying asset’s price will fluctuate moderately, they may take advantage of a vertical spread. Vertical spreads may reflect the trader’s outlook on the fundamental asset.
Whether the trader’s account is credited or debited depends on the kind of vertical spread deployed.
Debit and credit spreads are two kinds of vertical spreads. In a debit spread, the spread is paid for with debits, where you pay a net premium to enter a position. In a credit spread, the spread is received with credits, and you receive a net premium. When the market is going up, debit spreads are employed, and when it’s going down, credit spreads are used.
Both bullish and bearish vertical spreads are possible.
An investor may establish a bull call spread by purchasing one call option and selling another call option with a higher strike that also has an identical expiry date. Opened for a debit, bullish vertical call spreads are called debit spreads. Here, a price increase for the fundamental asset generates profits for the strategy.
Similarly, a bullish strategy known as a vertical put credit spread means trading one put option and purchasing another put option with a reduced strike and an identical expiry date. In a put credit spread, the credit is received upon the entry of a bull put spread.
Vertical spread option strategy example
Say you have purchased a call option for a premium of ₹6, granting you the right to buy shares at a strike price of ₹100. At the same time, you sold another call option for a premium of ₹3 with a strike price of ₹110, assuming the obligation to sell shares if the price exceeds this threshold.
- In this case, the debit is ₹3 (₹6 paid – ₹3 received), which represents the maximum potential loss if the underlying asset’s price fails to cross the strike price of the purchased call option (₹100).
- The breakeven point is ₹103, which is the purchased call option’s strike price (₹100) plus the net premium paid (₹3). The investor neither gains nor loses money at this price.
- If the underlying asset’s price increases beyond ₹110 (the strike price of the sold call option) at expiration, the maximum profit is capped at ₹7 (₹110 – ₹103).
Even if the underlying asset’s price reaches ₹115 at expiration, the profit realised does not increase beyond ₹7 (₹110 – ₹103).
This vertical spread strategy is a debit spread, as the investor paid a net premium upfront. It limits the potential loss and the potential profit (strike prices – net premium paid).
Conclusion
Rather than just buying options and hoping for the best, vertical spreads allow you to be more calculating. With careful execution of vertical spreads, you open up money making opportunities while still protecting yourself – which is the wise way to invest.
However, before you use this strategy, make sure you have a solid grasp of options trading and are well aware of the risks associated with such strategies.
FAQs
The primary risk associated with vertical spreads in options trading is the potential for the options to expire worthless, resulting in a loss of the trader’s initial investment. Market conditions, such as volatility and unexpected news or events, can also impact the profitability of the strategy. In a vertical spread, the trader’s maximum loss is limited to the net premium paid for a debit spread or the difference between the strike prices minus the net premium received for a credit spread.
Horizontal and vertical spreads differ mainly in the strike prices and expiration dates of the options used. A horizontal spread, also known as a calendar spread, involves options with the same strike price but different expiration dates. It is used to profit from changes in volatility over time. A vertical spread involves options with different strike prices but the same expiration date and is used when a moderate move in the underlying asset’s price is expected. Vertical spreads are mainly directional plays, while horizontal spreads focus on volatility.
Yes, you can sell a vertical spread. This involves selling an option at one strike price and buying another option at a different strike price, both with the same expiration date. Selling a vertical spread can be a bullish or bearish strategy, known as a credit spread, which generates income upfront. The trader’s profit is limited to the net premium received, and the risk is the difference between the strike prices minus the net premium.
The best spread for trading depends on the trader’s market outlook, risk tolerance, and strategy objectives. Narrow spreads, such as those ranging from zero to five pips in forex, are generally considered good as they allow traders to enter and exit positions at a lower cost. In options trading, vertical spreads are versatile and can be tailored to bullish or bearish market views, while horizontal spreads are best for capitalising on volatility changes.
Vertical spreads can be profitable if executed correctly and if the market moves in the anticipated direction. They offer a defined risk-reward profile, with profits limited by the maximum potential gain of the spread. Bullish vertical spreads profit when the underlying asset’s price rises, while bearish spreads profit when the price falls. The profitability of vertical spreads also depends on the trader’s ability to manage and adjust positions in response to market movements.