Stan Freifeld

Spread Trading: The Versatile Vertical Spread

    Tweet This

Free Trading Guides

Notice that when we constructed the bull vertical with calls (for a debit), the maximum gain was $3.19 and the maximum loss was $1.81. When constructed with puts (for a credit), the maximum gain was $3.16 and the maximum loss was $1.84. So assuming that you could do the bull vertical with either puts or calls for the amounts shown, which would be a more profitable spread?

Think about it. OK, drum roll please ...

The answer is that they would have exactly the same profit or loss, regardless of where the stock ended up at expiration. While it may appear that the debit spread is better since you can gain more and lose less, the difference (3 cents in this case) is actually an interest adjustment reflecting the fact that in one case (the debit) money is leaving the account, and in the other (credit), money is coming into the account and would be earning interest.

That difference is calculated by multiplying the maximum value of the spread ($5), by the risk-free rate of return (assumed to be 5%) in this example, for the number of days until expiration, or: 5 x .05 x 35/365 = .03.

I'm not going to go into the actual proof, but for those of you who need to be convinced, I'll tell you that it's easy to prove using the put-call parity equation that is discussed at length in Demystifying Call-Put Parity.

The real key to understanding the difference between the two spreads discussed above is to realize that they are synthetically equivalent. Also, you must know how to compare them to each other.

For example, if I could buy the bull call vertical for less than $1.81, that would be a good buy relative to receiving a credit of $3.16 for the bull put vertical. Likewise, if I could sell the bull put vertical for more than $3.16, that would be a good sale relative to buying the bull call vertical for $1.81.

While the examples I've shown generally relate to bull vertical spreads, the concept is exactly the same for bear vertical spreads. It would probably help your understanding, if you ran some bear vertical scenarios using the theoretical values in the above table.

For more on spread trading, see:

• Investor Jiu-jitsu -- The 88% Strategy Credit Spreads
  
• Calendar Spreads Pay Larger Premiums
  
• Bear Call Spreads Gone Bad
  
• Iron Condors vs. Condor Spreads

Stan Freifeld is an instructor with the Online Trading Academy. To learn more about him, read his bio here

This article originally appeared on The Options Insider Web site.