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Vertical Spreads

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Vertical spreads are also called money spreads. They are constructed with options at different strike prices. The first may be an out, at, or in the option depending on the risk desired. The second is a further out of money option. Each option is on the opposite side of the transaction, one will be written and the other will be purchased. They have the same expiration with a differing strike price. You can use two calls or two puts for vertical spreads, but both must be the same option type.

 

Long Vertical Call Spread

A Long Vertical Call Spread attempts to earn money from an underlying asset’s rise in price. The spread builder sells call options at a high strike price and purchases an equal amount of call options at a lower strike price using proceeds from the sale and additional funds. The position has an initial loss which must be overcome by positive performance. Both calls should expire at the same date. The higher strike price should be out of the money. The lower strike price can be in, at, or out of the money depending on the risk reward desired.

The purchased options will be exercised to provide you profit if the market price clears the strike prices. The sold option caps the earnings possible by the spread: if the earnings pass the higher strike price, they will be exercised by their holder. Your maximum profit is the higher strike price of the sold call. The worst case scenario is the market price falling or staying below both strike prices, resulting in the entire outlay for the position becoming worthless. This outlay was reduced by the sale of options, and the losses are lower than outright underlying asset ownership. The net premium paid is the maximum potential loss for the spread position. To reach breakeven, you need to pass the purchased call’s strike price by the cost of the premium after subtracting premium earnings from the sale of the high end call.

Short Vertical Call Spread

A Short Vertical Call Spread attempts to earn money from an underlying asset’s fall in price. The spread builder buys an out the money call at a high strike price, and sells an out the money call at a lower strike price. The difference in premiums generates an initially profitable income. If the underlying’s market price stays the same, or declines, then both calls remain out the money, and the income is kept as profit. This is the best scenario possible. If the market price rises beyond the sold option’s strike price plus the premium earned, profits are eroded and losses begin to occur.

The breakeven point is the strike price of the call sold, plus the initial premium income received. They will increase until they rise above the purchased call at the high strike price. The high strike price caps your losses. If losses exceed both strike prices, you will be exercised against at the sold strike price, selling the underlying. You will exercise the high option’s strike price, purchasing the underlying asset followed by a sale for liquid currency. The difference between the two are your losses, reduced by the income initially earned constructing the position. A spread builder can increase the initial income by increasing the gap between the two strike prices, but they also increase the potential loss.

Long Vertical Put Spread

A Long Vertical Put Spread attempts to earn money from an underlying asset’s fall in price. The spread builder buys one out the money put and reduces the cost of that option by selling another out the money put at a lower strike price. This creates an initial loss that must be overcome by the underlying asset’s price falling below the breakeven point of the position.

The position’s breakeven point is the purchased option’s strike price minus the net cost of creating the position. After the market price falls beyond the breakeven point, the loss will be replaced with profit. If market price stays the same or increases, the loss will remain in place. The loss is simply the net outlay for the position. Both puts will expire worthless. This is the worst situation possible. The best situation possible is the underlying asset’s market price falling below both strike prices. You will exercise the option you purchased, and the sold option will be exercised against you. You earn the difference between both strike prices as the profit, minus the initial cost paid creating the position.

Short Vertical Put Spread

A Short Vertical Put Spread attempts to earn money from an underlying asset’s rise in price. The spread builder writes an out the money put option with a high strike price, and purchases an out the money put with a lower strike price. This creates an initial income on the position that is eroded and then eliminated if the underlying asset’s market price decreases. If the market price stays the same or increases by the expiration date, the initial gain is kept as profit. This is the best situation possible. The initial gain can be increased, along with the risk of higher losses, by increasing the distance between the two out the money strike prices.

The breakeven point is the strike price of the option sold or written minus the initial profit earned from the position. If the share falls below that point, losses occur. The worst possible situation is the underlying asset’s market price decreasing below both strike prices. You will suffer the maximum loss, but it is capped by the lower long put option. You will exercise that option while the higher option is exercised against you. This results in buying the underlying at the higher strike price and selling it at the lower strike price, creating a loss which eventually erodes your initial profits.

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Option Profit Diagram Example

  • As you move to the right the underlying asset increases in value. The left side is lower in underlying price, while the right side is higher in underlying price.
  • As you move to the top the trade increases in profit. The gray horizontal line is the profit/loss difference point, the zero line where there is no profit and no loss. Higher above the line is higher in profit, lower below the line is higher in losses.
  • The blue line is the profit/loss at expiration. The purple line is the profit/loss now. Eventually the curving purple line will become the blue line.
  • A flat blue line below the grey zero line indicates limited losses at expiration. A flat blue line above the grey zero line indicates limited gains at expiration. A blue line that slopes down infinitely off the chart represents unlimited losses, while a line that slopes infinitely up represents unlimited gains.
  • A preference for limited loss trades is strongly recommended, remember that an estimated 60% to 70% of retail trader options expire worthless when purchased since prices need a reason to move in the money. If you have limited gains, they should preferably be both more likely than and higher than your potential losses. Always manage risk carefully.
  • Option diagrams created by TDAmeritrade “ThinkOrSwim” platform.