For traders who are familiar with trading derivatives, the importance of leverage would be amply clear. Derivatives such as futures and options allow a trader to make large trades with a small amount of capital. This is why these products are quite popular and in the right hands can be a great tool to generate huge profits. But just like every other financial product these too have some drawbacks.
Data from the exchanges suggest that nearly 90% of the options that trade in the market expire worthless. This means even though the profits made from options are in multiples of the initial amount invested, the probability of making profits is low.
Experienced traders understand this problem very well and hence they modify their trading strategy to create the right balance of probability and profitability. One of the most useful modifications is using a vertical options spread. But before we get into the details of this strategy, let us quickly revise the options basics.
Options basics recap
There are primarily two types of options – call option and put option. A call option gives the buyer the right but not the obligation to buy a stock at a certain date at a certain price. This certain date is known as the option’s expiry price, while the certain price is known as the strike price of the option.
The payoff diagram of a call option is as below. When the stock price starts rising above the strike price, the option becomes profitable and the profits can be several multiples of the cost of the option.
As seen above, if the option costs $1 and has a strike price of $11, we start earning profits once the stock price crosses $11. The payoff for a seller of the call is the exact opposite. Till the stock price remains below $10, the seller would be in $1 profit but as soon as the price crosses $11, he would be in loss.
So what is vertical spread in option trading?
As we saw above, a trader betting on the stock to go above $11 will buy the above call option. But what if the trader had a very specific price in mind, say $15. If the view is that the stock will go up but not beyond $15, there has to be a way to capitalize on that as well. After all, why should one pay for an unlimited upside which the call options offer, when one does not expect it to go beyond a certain price.
Here is where selling a call option comes in. In the above discussed view, the trader can play his view by buying the call option with $10 and selling a call option with $15 strike of the same expiry. This, in market parlance is known as vertical option spread or specifically a bull call spread.
An option spread is basically a combination of buying an option and simultaneously selling the other one. When both the options are of the same strike but different expiries, it is called a calendar spread or a horizontal spread. If both the strikes and expiries are different it is called a diagonal spread. If the options have the same expiries but different strikes as we discussed above, it is called a vertical spread.
Here we are going to explore vertical spreads in detail. Vertical spreads are used when the trader has a very specific view on the stock price for a fixed time range. For example, if the stock is currently trading at $8 and the trader expects the stock to trade in a range of $12 to $15 at the end of the month then a vertical spread is the perfect way to trade this.
What advantage does a vertical spread offer over a simple call? Spread involves selling an option which means that you also receive a premium for the sold option. It effectively reduces the cost of your structure. For example, the call option of $10 strike as discussed above costs $1. At the same time, a call option with $15 strike price costs $0.5. While a call option would cost you $1, by selling the other call option you are halving the price of the structure.
Vertical spread calls and puts: short vs long option trading
So what affects our payoff, stop loss and profit taking in trading a vertical spread strategy?
Vertical call spread
The payoff is simply the overlap of the payoffs of the two call options discussed above. So, our structure is initially at a $0.5 loss since that is the price we pay initially for the vertical spread. Now because the cost has decreased by $0.5, our breakeven stock price level also decreases to $10.5. What this means is that we start making profits from the moment the stock price crosses $10.5 instead of $11.
However, because we have sold the call option with $15, our upside is capped. That means our profits would stop increasing once the stock price crosses $15. However since our initial view any way was that the stock will not cross $15, this limitation will not affect our profitability.
Vertical put spread
The same numbers play out with put options with the direction reversed. So, if the trader’s view is that the stock price will fall but not beyond a certain price, he or she can buy a put spread instead of just a put option. Similar dynamics as discussed above will play out in this case as well.
The most important part though here is that since our initial cost halved from $1 to $0.5, the profitability effectively doubled. Since we can buy two vertical spreads for the cost of one call option, the profits generated are twice. Vertical call spreads help cut our costs and increase profitability as compared to just call options.