Vertical spread is a trading strategy that involves trading two options at the same time. It is the most basic option spread. A combination of a long option and a short option at different strike prices, albeit with the same expiration or maturity dates, are executed, and the trade is collectively called a vertical spread.
Vertical Spread in Options Trading
Options can be sold to collect time premiums because if an option is out of the money by the expiration date, it becomes worthless. Being out of the money means that the price of the share remains below the maximum limit that is set by the speculator.
For example, if the stock of Company X is trading at $930 per share, and the trader intends to bet that the market price stock will under no circumstances go over $100 per share, which is called the entry price. A trader can sell a $100 strike call option for $3, and if the option remains out of money until the expiration date, then they will get to keep the entire credit receipt worth $300 as profit.
However, the risk here is undefined as the price of the share can very well skyrocket beyond $0 per share. The capital requirement to sell the option can also be very large.
In the above example, in addition to selling a $100 strike call for $3, they can also buy a $105 strike call for $1.20, which is the short strike. There are three possible scenarios that can arise, including:
1. The price of the share remains under $100 at the date of expiry
The sale of $100 call options will result in a profit of $300, while the purchase of $105 call options will result in a loss of $130. The net profit of the vertical spread, as a whole, becomes $180.
2. The price of the share becomes $130 per share at the date of expiry
The option ends up $30 in the money, which means it crosses the entry price by 30 units. The sale of $100 call options will result in a $2,700 loss. However, the long call, i.e., $105 strike call for $1.20 is 25 units in the money, which results in a profit of $2,380.
The net loss of the vertical spread is limited to $320. The loss will remain the same at any share price of over $105.
3. Price of share ends up between the $100 to $105 range
In such a situation, the $100 strike call will remain in the money. For example, if the price of the share was $101, it results in a profit of $1. On the other hand, the $105 strike call will be out of the money and will become worthless. It means that there will be a $0 profit or loss. The net profit will become $1.
The break-even point for the strike call is the sum of the entry price ($100) and the short strike ($1.80), i.e., $101.80. Therefore, the trader will make a profit for any share price under the break-even point, and a loss for any share price below $101.80.
Advantages of the Vertical Spread Strategy
It enables the trader to sell time premiums by trading a vertical spread instead of selling a naked option. It also enables them to limit the total risk and use little capital.
When selling a vertical spread, the maximum profit is simply the net price for which the spread is sold. The maximum loss, which is also the capital requirement for the trade, is the difference between the width of the strike, and the entry price.
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