Vertical Spreads

Vertical Spreads

What is a Vertical Spread?

Vertical Spread is a two legged option strategy that involves buying or selling options in different strike price of the same expiry month. Vertical spread is commonly used strategy while online share trading. It is very to use this strategy by using trading apps developed by brokerage firms in India. The vertical spread is categorized into net debit and net credit strategy, where the former involves buying the options which makes the transaction as a net debit trade while the latter involves selling the options upfront which makes the strategy as a net credit strategy. Let us understand the two commonly used vertical spread strategies known as “Bull Call Spread” and “Bear Put Spread”.

Get to know what is vertical spread & impact of using it in stock trading

Bull Call Spread:

A bull call spread involves buying near the money call option and at the same time selling an out of the money call option of the same expiry month. In a bull call spread the outlook remains bullish where the maximum loss is capped while the profit potential remains spectacular in case things move as per the expectations.  It is a net debit strategy as one has to pay premium for buying the call option; however the cost is partially funded by selling an out of the money option, thereby bringing the breakeven closer at one hand while putting a check on the unlimited gains as well. The maximum loss in the strategy occurs when the price falls below the lower strike price whereas the maximum profit is locked when the price exceeds the upper strike price of call option sold and the breakeven is at the lower strike price plus the cost. To understand the strategy better let’s take an example-

XYZ Ltd is trading at 100 on June 15

Buy September 15, Rs 100 call at 10

Sell September 15, Rs 120 call at 5

Table 1

Bear Call Spread

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Bear Put Spread:

A bear put spread involves buying a near strike price put option and selling an (out of the money) lower put option of the same expiry simultaneously. Outlook remains bearish so in order to make the maximum profit the price of the underlying must fall, while the idea here remains to reduce the cost of buying the plane put option by selling the lower put and bringing the breakeven higher. The maximum gain is generated where the price of the underlying falls below the lower strike price while the maximum loss is occurred where the price goes above higher strike price i.e. the bought put option, although remains capped to the extent of net premium paid. The breakeven lies in the center at the higher strike price minus the net cost. Let’s take another example to understand better.

XYZ Ltd is trading at 100 on June 15

Buy September 15, Rs 100 put at 10

Sell September 15, Rs 80 put at 4

Table 2

Bear Put Spread

Important points to keep in mind:

Time to expiry– In order to take the maximum advantage one should look to buy far month/ longer term options in both the strategies because you need time to be right and  in instances where the price moves in adverse direction the price of the option does not fall rapidly.

Effect of time decay– Whenever the position is in profit the effect of time decay is positive for the strategy, however in instances where the position is in loss the effect of time decay is negative because the premium of the options bought would tend to reduce rapidly as the expiry approaches.

Identify clear support and resistance areas- As in both the spread strategies one is either bullish or bearish therefore it is advisable to identify clear support and resistance areas before initiating the trade.

Liquidity- As the strategy requires taking positions in far month contracts and out of the money options therefore one must be cautious in choosing the stocks / instruments in terms of its liquidity. Illiquid counters must be avoided for these strategies.

Capped profits – The second leg in the strategy which is aimed to reduce the net cost of the strategy has its limitations also. In instances where there are sharp breakouts on the projected direction, the profitability remains capped as one is short in out of the money option. In such times advance traders can exit the short leg to take advantage of the sharp price moves.

So it is very easy to use vertical spread strategy through online trading platforms like trading app or desktop software designed by brokerage firms in India.

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