Market Insights

Vertical spreads are one of the most common strategies in the options market because they can generate leverage with limited risk. This article will consider key points about bullish and bearish spreads.

Vertical spreads involve two “legs” on the same underlier to create a single position:

• One contract near the money is purchased at a higher cost
  • For bullish trades, this means a call with a strike above the current stock price.
  • For bearish trades, this means a put with a strike below the current stock price.
• Another contract is sold further from the money at a lower cost.
  • For bullish trades, this means a call with a strike further above the current stock price
  • For bearish trades, this means a put with a strike further below the current stock price

The legs of the vertical spread have the same number of contracts and the same expiration dates.

Example of a Bullish Vertical Spread

We’ll take as an example Apple (AAPL), one of the busiest names in the options market. It was trading around $182.40 around the middle of Tuesday’s session.

Say an investor thinks it might return to its January high around $195 over the intermediate term. He or she might consider a bullish vertical call spread using the standard monthly contracts expiring on the third Friday of next month (June 21).

The June 190 calls were offered for about $2.24 and the June 195 calls had a bid price of about $1.12.

The trader could potentially buy the June 190s and sell an equal number of June 195s for a net cost of $1.12, excluding commissions. (That’s $2.24 minus $1.12.)

The position will have a maximum value of $5 if AAPL closes at $195 or higher on expiration. That’s a potential profit of about 346 percent from the stock moving about 7 percent. The spread will expire worthless if the iPhone maker stays below $195. Its breakeven is at $196.10.

Example of a Bearish Vertical Spread

Tesla (TSLA), another highly active name, could be considered for a potentially bearish trade. It was trading around $174.50 on Tuesday.

Say an investor thinks it might return to its April low near $139 over the intermediate term. He or she might seek a bearish vertical put spread using the standard monthly contracts expiring on June 21.

The June 145 puts were offered for about $1.63 and the June 140 puts had a bid price of about $1.12.

The trader could potentially buy the June 145s and sell an equal number of June 140s for a net cost of $0.51, excluding commissions. (That’s $1.63 minus $1.12.)

The position will have a maximum value of $5 if TSLA closes at $140 or lower on expiration. That’s a potential profit of 880 percent from the stock moving 20 percent. The spread will expire worthless if the EV maker stays above $145. Its breakeven is at $144.49.

Cost Management with Vertical Spreads

Buying a higher-cost option and selling a lower cost option reduces the cost of the overall position. The lower cost can then increase leverage from prices moving in the intended direction.

Traders may use vertical spreads for “binary events” like earnings, when stocks could make sudden moves from one session to the next. They can generate large gains on a percentage basis, profiting from potential moves at a low cost. This reduces the amount of capital investors need to to risk.

Hedging is another potential use of vertical spreads. An investor could own a stock facing a potentially risky event like earnings. They might not want to sell, especially because they think it might jump on the news. He or she might consider buying a put spread below the current price. It could profit from a drop with limited cost, protecting against a decline while letting them benefit from a potential rally.

Limitations of Vertical Spreads

Vertical spreads have some potential drawbacks.

First, vertical spreads realize their full profit potential only close to expiration. If the stock moves in the intended direction, the option sold short will gain value as well as the option purchased. As a result, traders may need to wait for time decay to erode the value of the short leg. It may be difficult to exit quickly.

Second, vertical spreads have limited profits. If prices move move above the higher strike in a bullish trade, the spread’s width caps its potential value. Owning shares or simple calls, on the other hand, have infinite potential upside. (But shares and simple calls also have more risk because they cost more.)

In conclusion, vertical spreads can be a useful strategy for traders to have their toolkit. They can profit from potentially sharp moves around big events with limited risk. Traders can also use them to hedge existing stock positions. However they may require longer hold periods to realize the full gain.

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