A vertical spread is an options trading strategy that involves the matching sale and purchase of options of the same type and with the same expiry date, but with a different strike price. The idea behind a vertical spread trade is to create a small window of unprofitability, the spread, between two profitable outcomes.
Vertical Spread Example
A trader wishing to set up a vertical spread on an equity priced at $35 per share can sell a call option at a $35 strike price for $3 and buy another call option at a $40 strike price for $1. The premium gained from selling the $35 call option ($3) is greater than the premium paid for buying the $40 call option ($1) which means you would bring credit.
This means that the trade is profitable when the price is slightly above $35 and slightly above $40, leaving only a small area of unprofitability between these two points, which is the spread. Ideally you want the strike prices to finish out of the money so the options expire worthless and you can keep the credit you brought it.
Vertical Spread in Trading
A vertical spread is most commonly used when the trader is confident of a significant price move, but wants to protect against the downside. In the example of a $40 strike price, any price well above $40 will mean an increasing rate of profit on the trade, as the income earned from the $40 call will outpace the payout made on the $35 call.
However, if some event causes the price to not rise, or even to fall, then the trade will still be profitable as a result of the beneficial premium spread from the sale of the $35 strike price option.
A vertical spread is another example of highly sophisticated derivatives trades that allow traders to craft complex and nuanced positions that perfectly match their expectations of a security’s potential price action.
An equity trader who sees a potential for a price increase yet notices that this potential may fail to occur for some given reason may choose to pass on that trade. However, an options trader can craft a perfect position as a response to this scenario using a vertical spread trade.
A vertical spread is an options trading strategy that is most commonly used when a sharp price move is expected alongside the existence of a potential downside. The vertical spread allows the trader to gain a beneficial exposure to the positive price move, while also narrowing the window for a potentially unprofitable trade.