Vertical Spreads for Up and Down Markets

Verticals are among the most basic option-spread strategies. They get their name from the fact that these spreads are created using two options within the same expiration month, but with different strike prices, which are typically listed vertically on most options quote screens. Hence the name "vertical spreads."

Options spreads can be long or short and created with either puts or calls. In most cases, the investor has a directional view and expects the stock to move higher or lower. For example, in a long call vertical spread, which we discuss here, the investor is typically bullish and is positioning for a rally in the stock. Other verticals include short call vertical spreads, short puts vertical spreads, or long put vertical spreads.

Let’s keep things simple and discuss the long call vertical spread. Remember, a call buyer enters a contract and has the right to buy the underlying stock at a fixed price through the expiration. Most investors understand that this call costs money, known as a premium or debit, and that the entire investment is at risk if the stock heads south rather than north.

A long call vertical spread is also a bullish strategy, but the investor is buying one call option and selling another at a higher strike price with the same expiration date. While the long call costs a premium to purchase, the investor is also selling a higher strike call and the premium collected on this short call helps offset some of the cost of the purchase of the long call. Nevertheless, like a long call, the investor pays a debit and that investment is at risk.

Figure 1: Long Call Vertical Spread Risk Graph

Figure 1 shows a typical risk-reward profile for a long call vertical spread. The risk is limited to the debit and the potential profits are equal to the difference between the two strikes minus the debit. The breakeven point at expiration is the lower strike price plus the debit. The best potential profits happen at or near the expiration if the stock price is above both strikes at the expiration. At that point, the spread is in the money.

Here’s a simple example to illustrate. Shares of XYZ are trading for $104 and the XYZ December 100-strike calls are trading for $7. Meanwhile, XYZ December 110-strike calls are trading for $2. The investor buys the lower strike for $7 and sells the higher one for $2, to enter a Dec 100 - 110 vertical call spread. A $5 debit is paid ($7 -$2) and so the trade breaks even at $105 (or the lower strike plus the debit). The potential gain is $10, or a $5 profit, if shares move north of $110 and the spread widens to $10. The risk is the entire $5 debit if shares falter below $100 and the options expire worthless. The spread can also be closed prior to expiration (unless the stock really tanks and there is an unlikely situation with no more buyers, or bids, for the call options).

Conclusion

If a long call vertical spread is a bullish play, then being short the spread is a bearish play. Meanwhile, an investor might open a long put spread if he expects the underlying stock to move lower or a short put spread if he anticipates a move higher. Like buying calls and puts, these types of vertical spreads are often initiated when the investor expects a vertical, up and down move, in a security or market.