Josip Causic

Vertical Spreads 101

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This article originally appeared on The Options Insider Web site. 

Editor's note: This is the first of a five-part series on vertical spreads. This article will introduce the concept of the vertical spread and define its four main components, while the next four articles will deal with individual vertical spread strategies.

A vertical spread is a trade in which the simultaneous buying and selling of the same class option (i.e., either puts or calls, but not both together) is performed on the same underlying stock. Verticals must be done on the same expiration month, and they involve the selection of different strike prices.

The table below visually represents the four components mentioned above:

The first three categories (underlying, option class and month of expiry) are easy to comprehend. The buying and selling is done on the same underlying. Either calls or puts are used (not a mix of both). Moreover, the action of buying a put and selling a put (or buying a call and selling a call) is done using the same expiry month. So there is not much variation: same underlying, same option class (calls or puts), and same expiry month. So there is not much variation: same underlying, same option class (calls or puts), and same expiry month.

However, traders love choices, and options on equities are simply just that: choices. One of my students asked what would happen if we buy a call and sell a put at the same strike price on the same underlying and on the same month.

The figure below uses the same four components that were used to describe the basics of verticals, yet two components are changed (the bold ones). 

Two components from the vertical spread have reversed their places: The option class is now different and the strike prices are now the same. If a trader buys an at-the-money (ATM) call and sells an ATM put, then the trader has traded the same strike prices using two different option classes. This strategy is known as a synthetic long.

There is also another variation, which would still have the same strike prices and different option classes but an ATM put is bought and an ATM call is sold. This strategy is a synthetic short. These are NOT vertical spreads.

The bottom line is that changing any of these four components would create a completely new option strategy.