One of the ways active traders can secure bullish or bearish exposure with limited risk is by using a vertical spread. In this blog article, we’ll break down what this strategy is and how it can help you reach your financial goals.
What Is a Vertical Spread?
A vertical spread is an options trading strategy in which a trader simultaneously buys or sells calls or puts on the same contract at different strike prices. The immediate result is a bullish or bearish position in the market, as well as a net credit or debit created by the written and purchased options.
In the live market, this options trading strategy comes in four types:
- Bull call spread: The bull call spread is executed by buying a call option while selling a call option with a higher strike price.
- Bear call spread: A bear call spread is implemented by selling a call option while buying another call with a higher strike price.
- Bull put spread: The bull put spread is executed by selling a put option while purchasing another put at a lower strike price.
- Bear put spread: A bear put spread is implemented by buying a put option while selling another put option at a lower strike price.
The strategies enable the trader to secure either a bullish or bearish market exposure. In comparison to outright futures, each spread’s potential outcome is known and not subject to the extreme gains or losses created by unexpected volatility.
Benefits of Trading Vertical Spreads
Although understanding the nuances of vertical spreads can be challenging, they do offer traders several key advantages. Here’s a look at three of the most prominent:
Risk vs. Reward
Perhaps the greatest reason traders execute vertical spreads is that they offer a finite risk versus reward matrix. In each type of strategy, both the maximum risk and reward are quantified, which provides a major advantage when optimizing an active trading portfolio. With the vertical spread, there are no surprises because the market is engaged in a specific, rigid fashion.
As in the futures trade, it’s possible to open both short and long positions with vertical spreads. These strategies are also viable on any asset that features an options chain. Among the most popular are the equities indices, ag commodities, metals, and energies.
A vertical spread strategy may be implemented on near-term or deferred-expiry options contracts. In this fashion, a trader can fully customize the trade or investment’s horizon.
Case Study: Executing a WTI Bull Call Spread
To illustrate how vertical spreads function, let’s take a look at a bull call spread for West Texas Intermediate (WTI) crude oil. Assume that it’s Memorial Day and July WTI is trading at $65.00. Trader A believes that $65.00 is within 5 percent of the year’s probable high. By executing a bull call spread in October WTI, profits from a modest rise in asset pricing may be realized.
In order to put on the WTI bull call spread, Trader A takes the following steps:
- They purchase one October WTI at-the-money (ATM) call with a strike price of $65.00.
- At the same time, they will sell one October WTI out-of-the-money (OTM) call with a strike of $70.00.
Upon executing the bull call, Trader A’s position is as follows:
- Maximum Profit = (Difference in Strikes) – (Premium)
- ([$70.00 – $65.00] × 100) × 10 – ($4,650 – $2,700) = $3,050
- Maximum Loss = Paid Premium
- ($4,650 – $2,700) = $1,950
From a practical standpoint, it can be challenging to figure out profitability and premium allocations for the vertical spread strategy in live market conditions. Due to this fact, it’s a good idea to have access to a futures options calculator or software platform capable of automating computations.
Want to Learn More About Vertical Spreads?
Options pricing and spreads are among the most complex topics in finance. That’s why it’s a good idea to boost your options IQ before jumping into the market with both feet.
If you’re interested in learning more about options, check out Daniels Trading’s online educational suite. Featuring webinar tutorials, trading guides, and CME-direct materials, it is an indispensable resource for getting up to speed on all things derivatives trading.