A vertical spread is the combination of a long and short option at different strikes but in the same underlying for the same expiration.
There are call vertical spreads and put vertical spreads. A call vertical spread is the purchase of one call and the sale of another at a different strike for the same expiration. A put vertical spread is the purchase of one put and sale of another at a different strike for the same expiration.
Vertical spreads can be bought or sold, and either strategy involves defined risk and defined profit.
Long Vertical Spread
Buying a vertical spread is a strategy commonly used when price is expected to move toward or through a specified price level.
Long Call Vertical
In the case of a long call vertical spread, price is expected to rise to or through the upper strike of the spread. A lower-strike call option is purchased and a higher-strike call option is sold for a net debit.
The lower-strike call gains value as price rises because it is long deltas, but the higher-strike call option loses value as price rises because it is short deltas. The lower-strike call is either ITM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the higher-strike call. For this reason, the long lower-strike call carries more deltas than the short higher-strike call negative deltas, giving the long call vertical spread positive deltas as a combined position.
The spread can only lose the amount paid for the spread, which defines the risk. The spread can only gain the width of the spread minus the credit collected, which defines the potential profit.
Long call verticals are typically bought with the long option being ITM or ATM with an expectation of price rallying to or through the short strike. This is a bullish strategy designed to limit risk to the debit paid with potential for the spread to expand to the width of the strikes.
Long Put Vertical
In the case of a long put vertical spread, price is expected to decline to or through the lower strike of the spread. A higher-strike put option is purchased and a lower-strike put option is sold for a net debit.
The higher-strike put gains value as price declines because it is short deltas, but the lower-strike put option loses value as price decline because it is long deltas. The higher-strike put is either ITM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the lower-strike put. For this reason, the long higher-strike put carries more negative deltas than the short lower-strike put positive deltas, giving the long put vertical spread negative deltas as a combined position. The spread can only lose the amount paid for the spread, which defines the risk. The spread can only gain the width of the spread minus the credit collected, which defines the potential profit.
Long put verticals are typically bought with the long option being ITM or ATM with an expectation of price declining to or through the short strike. This is a bearish strategy designed to limit risk to the debit paid with potential for the spread to expand to the width of the strikes.
Short Vertical Spread
Selling a vertical spread is a strategy commonly used when price is expected to move away from a specified price level.
Short Call Vertical
In the case of a short call vertical spread, price is expected to decline away from the lower (short) strike of the spread. A higher-strike call option is purchased and a lower-strike call option is sold for a net credit.
The lower-strike call loses value (benefits the spread) as price declines because it is short deltas, and the higher-strike call option loses value as price declines because it is long deltas. The lower-strike call is either OTM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the higher-strike call. For this reason, the long lower-strike call carries more negative deltas than the higher-strike call positive deltas, giving the short call vertical spread negative or short deltas as a combined position. The paired position can only lose the width of the spread minus the credit collected at entry, which defines the risk. The spread has a max gain of the credit collected, which can only erode to $0, which defines the potential profit.
Short call verticals are typically sold with the short option being ATM or OTM with an expectation of price staying beneath the short strike. This is a bearish strategy designed to collect premium but limit upside risk in the event of a sharp advance in share prices.
Short Put Vertical
In the case of a short put vertical spread, price is expected to advance away from the higher (short) strike of the spread. A lower-strike put option is purchased and a higher-strike put option is sold for a net credit.
The higher-strike put loses value (benefits the spread) as price advances because it is long deltas, and the lower-strike put option loses value as price advances because it is short deltas. The higher-strike put is either OTM or closest to the money, making it more directionally sensitive to moves in the underlying asset price (stock prices) vs. the lower-strike put. For this reason, the short higher-strike put carries more positive deltas than the lower-strike put negative deltas, giving the short put vertical spread positive or long deltas as a combined position. The paired position can only lose the width of the spread minus the credit collected at entry, which defines the risk. The spread has a max gain of the credit collected, which can only erode to $0, which defines the potential profit.
Short put verticals are typically sold with the short option being ATM or OTM with an expectation of price staying above the short strike. This is a bullish strategy designed to collect premium but limit downside risk in the event of a sharp decline in share prices.
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