Stan Freifeld

Spread Trading: The Versatile Vertical Spread

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What's interesting about these spreads is that you can also construct the bull vertical with puts or the bear vertical with calls (see why Not All Call Buying is Bullish). These spreads will be done for credits, since you are selling the more expensive option and buying the less expensive one.

The following table should clear up any confusion:

Let's take an example using the above prices for options on XYZ stock, which is currently trading at $55. Suppose you're bullish on the stock over the next 35 days. You could buy a 55 call option for $3.18.

If XYZ increases by 10% to $60.50 at expiration, you will make $2.32 for each contract you bought. On the other hand, if you were wrong about the movement of XYZ, and it finishes constant at its current level, you'll lose the full amount of the purchase. In fact, just to break even, XYZ will have to increase to $58.18 at expiration.

How a Spread Trader Uses Verticals

Now a spread trader might have approached this situation differently.

He could buy the 55 call for $3.18 and simultaneously sell the 60 call for $1.37, resulting in a net debit of $1.81. That's a reduction of 43% in the trader's net outlay. If the stock stays at $55, he still loses the entire debit, but it's still 43% less than what he would have lost on the call. Also, the breakeven point is now lowered to $56.81 versus $58.18 for the lonely call.

So what's the problem? Why would anyone just buy a call?

Like everything else regarding options trading, there's a trade-off. To get this reduced cost and lower breakeven point, you're giving up the unlimited potential of the call purchase. No matter how high the stock goes, the value of the spread can never exceed $5.

Consequently, since we paid $1.81 for the spread, the maximum profit that can be made is $5 – $1.81 = $3.19. For example, with the stock at $63 the 55 call = $8, the 60 call = $3, and the spread is worth $5. With the stock at $75, the 55 call = $20, the 60 call = $15, and the spread is still worth $5.

Puts vs. Calls

Suppose now that we were to construct this same bull spread using puts. We could sell the 60 put for $6.08 and buy the 55 put for $2.92, yielding a net credit of $3.16. If XYZ is above $60 at expiration, both puts will expire worthless, so the spread will also be worthless and we get to keep the credit of $3.16.

If XYZ is below $55 at expiration, let's say $52, then the 60 put will be worth $8, and the 55 put $3, and therefore the spread will be worth $5. Since we sold it for $3.16 and now we have to buy it back for $5, we end up with a net loss of $5 - $3.16 = $1.84. This will be the amount of loss for any stock price less than or equal to $55 at expiration.