Vertical Spread Overview
A vertical spread is an options strategy which allows option traders to bet on the direction of the market with a limited risk and limited return profile. Traders utilizing a vertical spread are typically not 100% sold on the direction or strength in the trend.
Constructing a Vertical Spread
A vertical spread can be constructed by buying and selling calls (or puts) with the same expiration date and underlying security, but with different strike prices. The idea is to go long on one option and short the other to create a bullish or bearish spread.
Vertical spreads are created by using call options or put options, but not by mixing both together. A bull call spread or bull put spread can be constructed by purchasing at the money calls or at the money puts and selling out of the money calls or puts to somewhat offset the cost.
Conversely, a bearish vertical spread can also be created with calls or puts. However, the options will swap positions as far as which one is bought and which one is shorted. A bear call spread will consist of a short call at the money and a long call out of the money while a bear put spread will consist of a long put at the money and a short put out of the money.
Debit spread versus credit spread
A vertical spread can be put on as a credit or debit on initiation. It is important to understand why a trader would create one versus the other. Vertical credit spreads are theta decay plays, entered by traders who believe that there will be very low volatility up until expiration.
For a bull put spread, the trader who shorted the higher strike put will want to see the stock close above that price or very close to the higher strike to make a profit. Conversely, a bear call spread profits most when the stock closes below or at the strike price of the short option. These trades have a clear risk and reward scenario. We just discussed the reward; the risk is equal to the difference between the strike prices of the options minus the net credit received.
Debit spreads, on the other hand, are taken by traders who want a directional bias. Bull call spreads make money when the stock moves above the OTM call strike while bear put spreads profit as the stock moves below the lower strike put. These are more directional trades rather than time decay trades.
Options strategy - Vertical Spread
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