Vertical Spreads - What They Are and How you Can Use Them
Vertical spreads involve a combination of options positions where an equal number of options are simulatneously bought and sold but all positions have the same expiration date. To be clasified "vertical" and not diagonal spreads, the expiration dates need to be the same.
As an example, you might buy to open 10 call options at a strike price of $35 and simultaneously sell to open the same number (10) of call options at a strike price of $40. Because one strike price is $5 above (or below) the other, this makes it "vertical". All positions will have the same expiration month.
Vertical spreads can take the form of either debit spreads or credit spreads which respectively, have their own risk to reward profile. A credit spread is entered with the objective that the price action of the underlying should remaining away from the option strike prices. You receive a credit to your trading account because the value of the options you've sold will be greater than those which you have purchased. The reason for this is, because the sold options will be closer to "the money" than the bought ones.
The easiest way to illustrate is with an example. Let's say you believe the price action of a security is going to rise or remain about the same over the next month. In this case, you would open a "bull put spread". It is called this because you are bullish on the underlying but you're also using put options to trade with. Put options with a strike price lower than the current market price, will have more value than other put options with strike prices that are even lower.
The maximum profit will be the credit you receive into your account but the risk you're taking on is greater than what you receive.
The maximum loss will be the difference between the strike prices, less the credit received, per 100 shares covered by each options position. This risk can be managed however, by making adjustments.
Debit vertical spreads on the other hand, work the opposite way. Using our example above, if you're bullish on a security, you would open a "bull call spread" - because now you're using call options. Unlike the credit spread, in this case you want the price action of the underlying to penetrate the strike prices of your positions - the further the better in fact.
You incur a debit from your account because the value of the bought positions will be greater than the sold positions, thus leaving an overall debit. The only downside to debit spreads is, that your profit potential is limited.
Maximum profit will be the difference between the strike prices, less the debit (cost) of opening the positions - and this is at expiration date. You can of course, close out your postions at any time.
The maximum loss you can incur with debit spreads is limited to the cost of the spread.
Vertical Spreads - Advantages
The biggest advantage of vertical spreads of simple bought options positions, is the flexibility they give you, to either adjust positions by rolling them in the case of credit spreads, or in some scenarios involving debit spreads, buying back your sold position for much cheaper than the original sale price - and then the price action moves in your favour.
Vertical spreads can also give you more leverage on your invested amount, than simple buy positions - at least in the case of debit spreads. Because the overall spread position is much cheaper than a simple "long" position, it means you can have a greater number of options contracts for the same price. If the price action moves in your favour, the profit is greater.
The downside is, twofold:
1. You will incur double the brokerage costs for vertical spreads
2. Many brokers' trading platforms don't include spread positions, which means you have to "leg in" to the each side of the trade, or ring the broker on the phone. Phoned-in positions usually incur greater brokerage costs than those transacted via the internet.