Vertical Spread: Meaning and Definition
A vertical spread also called a credit spread, involves buying and selling options of the same class (Call or Put) but different strike prices. Vertical spreads can be bullish or bearish. The goal of a bull vertical spread trade is to profit from an increase in stock price while maintaining low risk.
Vertical spreads can also be used by traders looking to speculate on volatility in their favor. They may be paid for with long-term or short-term capital gains taxes depending on the longevity of ownership of stocks. In addition, using stocks as part of your strategy may limit your ability to use Options as a potential tax advantage.
Vertical spread trading, or vertical spreads, is a combination of two options with different strike prices or expiration dates. In a vertical spread position, you buy one option and sell another Option at a different strike price to generate a net credit. This differs from traditional horizontal spreads in which Options have equal strikes and expire on the same date. Vertical spreads work best when you believe that a market will either increase or decrease substantially over time.
Types of Vertical Spread
Vertical spreads can be either credit or debit. If we buy an Option and then sell another Option of a similar type and expiration date, we enter a vertical credit spread. This means you get to keep part of your investment if things do not work out in your favor. You would lose only what you paid for trading costs such as brokerage charges, commissions, and bid-ask spreads.
Debit vertical spreads are created by selling one Option and buying another at a higher strike price. The maximum loss that can occur in a debit spread is equal to your initial investment (credit) plus any additional costs incurred while executing trades (commissions). A minimum gain has no predefined value because it varies with volatility and time until expiry.
Vertical Put spreads are bullish strategies where you profit from falling stock prices. Vertical Call spreads, on the other hand, are bearish plays where you profit from rising stock prices. Both plays involve buying and selling options on the same underlying asset but with different strikes and/or expirations.
Examples of Vertical Spread
Consider you could sell a September Rs. 50 Call and buy a September Rs. 70 Call. If, after expiration, they turn out to be worthless, you will keep your profit because both sides of your trade will be out of the money. Your profit would be (strike price of sold Call - strike price of bought Call x 100) x quantity (number of contracts). A vertical spread involves an equal debit and credit when executed. This allows for unlimited risk if one leg starts losing value very quickly or gains quickly before the expiry date.
Vertical spreads allow you to benefit from two market scenarios: one where your stock price rises and the other where it falls. The only scenario in which you lose money is if your stock price remains the same, which at least with Options, is unlikely to happen for very long.
Vertical spreads can be great tools for investors who want to hedge or speculate in their stocks and aren’t interested in them until they either rise or fall by a specific amount. They can also be useful when investing when volatility is expected to increase so that an investor can still profit even when their stock doesn’t move much.
Q1. Should I use a Call Option if I use vertical?
Ans. The vertical spread helps you profit if there is a sharp price rise. Although Call Options are mainly used to profit from a price increase, they can also be used to protect an existing long position by buying Call Options at a lower strike price. As the underlying asset rises, the gain will occur in both positions. Vertical spread can be structured using either all Calls or all Puts or combinations of both Calls and Puts.
Q2. How to manage vertical spread in Options?
Ans. Vertical spread options are best used to manage risk or to exploit minor opportunities. For instance, let’s say you are bullish on stock XYZ. You have an existing long position in 100 shares and it’s now trading at Rs. 30 per share. You expect that in 1-2 months, your outlook will be even more positive and you’d like to take advantage of that to increase your return on investment without taking too much risk.
One way to do that would be selling a vertical Call spread while simultaneously buying a longer-dated vertical Put spread. In simple terms, a vertical Option strategy is where two positions with identical expirations but different strike prices. Both positions must have a positive delta because one position cannot move in a direction opposite from another unless there is underlying movement.