Risk, Reward, and the Vertical Spread

Options are an excellent vehicle for taking a directional view on a particular stock or the market as a whole. Having said that, I do not believe in buying puts or calls outright as time decay is the option owner’s worst enemy. So, we will discuss a simple and straightforward options strategy, the vertical spread. Here is a profit loss graph of a vertical spread using calls.

You own a call at strike A and have sold a higher strike call, strike B. Generally the stock or index is at or below strike A and your price target is strike B. Both options have the same expiration date.

A vertical spread can never be worth less than zero or more than the differential between the strikes. Your risk is your net debit and your maximum profit is the difference between the strikes minus the debit paid, with the break-even point being strike A plus the debit paid.

A vertical put spread looks like this:

You have sold a lower strike put, strike A and you have bought a higher strike put, strike B. Generally speaking, the stock or index is at or above strike B and your target price is strike A. Once again, you cannot lose more than your net debit paid and your maximum reward is the difference between the strike prices minus the net debit. And your break-even point is strike B minus the debit paid.

With both vertical spreads there is no additional margin required beyond the debit paid as you are not net options short.

In both spreads, if your view was correct, then you want implied volatility to decrease because the near to the money option you sold will decay faster than the now in the money option you bought.

If, on the other hand, your view was wrong then you want implied volatility to increase. This is because it will increase the value of the out-of-the-money option you bought faster than it will the now nearly-at-the-money option you are short. Also, an increase in implied volatility increases the likelihood of a price swing, putting you back on the path to a profit.

In both spreads, it is a good idea to unwind the position before expiration. This is particularly true of American style stock options with physical delivery. You do not want your inexpensive vertical spread to turn into the underlying value.

So, we see that a vertical spread is an excellent, easily managed and affordable way to take a directional view on a stock or index.

For smarter trades subscribe to Tradespoon!