How to Help Manage Risk with Vertical Spreads

August 30, 2023 Beginner
Learn how vertical spreads can potentially be a cost-effective way to speculate on direction.

A vertical spread includes the sale of an option combined with the purchase of an option.

Depending on the target price a trader has set on a stock they're trading, a vertical spread might allow them to be more capital efficient as they pursue their trading objectives.

What is a vertical spread?

First, the basics of a vertical spread. A vertical spread1 includes the sale of an option combined with the purchase of an option. A long vertical call spread is the purchase of a call option on a stock and the sale of a higher-strike call with the same expiration. So, for example, if a stock is trading at $185, a trader might buy the 190-strike call and sell the 195-strike call as a spread.

A long vertical put spread involves buying a put and selling a lower-strike put with the same expiration. For example, if a stock is trading at $185, a trader might buy the 180-strike put and sell the 175-strike put as a spread.

Although there's no guarantee in how a stock will perform, buying a call or a call vertical spread typically has a bullish bias, meaning it can potentially increase in value as the underlying stock rises. Conversely, buying a put or put vertical spread typically has a bearish bias, meaning it can potentially increase in value as the underlying stock falls. When trading options, premiums and expiration dates are involved. An out-of-the-money(OTM) option will expire worthless, and the trader will lose the entire premium paid.

With both the single-leg strategy and the long vertical spread strategy, risk is generally limited to the premium paid, plus transaction costs. As a result, the vertical spread might represent a more cost-effective way for traders to pursue their trading objectives. The premium collected from a short strike might potentially offset some of the premium paid for a long strike. On the other hand, it's generally accepted that a trader limits their potential upside with a spread. The maximum potential gain for a long call or long put vertical spread is typically the difference between the two strike prices minus the debit paid. Like with long single-leg options, the maximum risk for a long vertical spread is typically the premium paid. However, transaction costs might be higher with spreads than single-leg options.

Option chains

Below is an example of a typical option chain. The underlying stock is trading at $186.44, and the options expiring in June 2023 have 30 days until expiration. A trader might set a short-term price target of $195 for the stock. The trader needs to decide whether they'd rather buy the 190-strike call at its fair value of $2.43, or the 190-195 call spread at $1.43.

When making these decisions, traders should consider the 100 multiplier for listed U.S. equity option because each standard equity options contract represents 100 shares of the underlying asset. So, in dollar terms, the total premium for the 190-strike call is $243, and for the call spread, it'd be $143, plus transaction costs.

The image shows the 190 call is offered at $2.43. The bid for the 195 call is $1.

Source: thinkorswim® platform

For illustrative purposes only. Past performance does not guarantee future results.

The image below compares the expiration payout graphs for the two choices. If the underlying stock is trading at the target price of $195 on the day the options expire, and the trader bought the 190 call, the payoff would be:

$195 minus the strike of 190, minus the $2.43 premium paid, times 100 = $257, minus transaction costs.

However, with the call spread, the payoff would be:

$195 minus the strike of 190, minus the $1.43 premium paid, times 100 = $357, minus transaction costs.

The two charts compare the potential payouts with a single-leg call option versus a call option spread. The spread shows a lower initial cost and a higher payoff at the target price, but the upside potential is limited to the short strike.

Source: thinkorswim platform

For illustrative purposes only. Past performance does not guarantee future results.

Analysis of the option spread example

In the call spread example above, an expiration date price of $195 in the underlying stock is the point at which a trader would receive the maximum payoff potential. However, if the trader had purchased the 190-strike call outright, the upside potential would continue if the underlying stock rose higher than $195. For example, if the stock price was $197 at expiration, and the trader had bought the 190-strike call, the payoff would be $197 minus the strike of 190, minus the $2.43 premium paid, times 100 shares = $457, minus transaction costs.

It's difficult to determine whether an option trader would have continued with the trade until the priced reached $197. Some option traders look for exits, especially if the underlying stock reaches the target price. If $195 was the targeted exit point, the vertical spread would allow the trader to benefit from the entire move to $195 but at a lower entry cost than a single call.

On the other hand, if the underlying stock remained at $186.44 or went down, both the long call vertical spread and the single call without the spread would result in the loss of the entire premium, plus transaction costs. The single call strategy had potentially more capital at risk than the vertical spread.

1An options position composed of either all calls or all puts, with long options and short options at two different strikes. The options are all on the same stock and of the same expiration, with the quantity of long options and the quantity of short options netting to zero.

2Describes an option with no intrinsic value. A call option is out of the money (OTM) if its strike price is above the price of the underlying stock. A put option is OTM if its strike price is below the price of the underlying stock.

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Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options" before considering any options transaction. Supporting documentation for any claims or statistical information is available upon request.

With long options, investors may lose 100% of funds invested. Spread trading must be done in a margin account. Multiple leg options strategies will involve multiple commissions.

Investing involves risks, including loss of principal.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Past performance is no guarantee of future results.

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