Vertical option spreads are trading strategies that involve two trading options happening simultaneously i.e., puts or calls. A vertical spread is preferred for trading because the revenue received from a sold option can compensate for the cost of a purchased one.
There are four types of basic vertical option spreads namely, bull put, bear put, bull call and bear call. According to tastytrade, vertical spreads allow us to trade directionally while clearly defining our maximum profit and maximum loss on entry (known as defined risk).
The following are some of the basic features of vertical-spreads.
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Basic features of vertical spreads
Buying and selling of puts or calls
In vertical spreads, a trader buys an option and sells it at an increased strike price to gain a profit while using both calls and both puts.
Different legs
Vertical spreads involve two legs, one for purchasing options when the market is favorable while the other is for writing options.
Types of vertical spreads
Bull call spread
It is the optimal strategy that is often used solely for profit. A bull call spread is characterized by a long call for a lower strike price and another with a short caller that gets a higher strike price.
A loss in bull call spread is realized only from the net premium paid for the market position. On the other hand, a profit in bull call spread is the same as the difference in the calls’ strike prices and less the total amount of premium paid to get the market position.
Bull call spreads simply make profits when the market price of the shares increases.
Bear call spread
This spread option has two parts, with one part selling a call option and receiving the option’s premium payment. The second part involves buying a second call option along with the same expiry date but this time with a higher strike price.
Since the value of the call sold is less than the heightened price of the call purchased, it leads to a greater premium amount on the first leg as compared to the second leg.
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Bull put spread
This is a spread option that involves collecting the premium option and ensuring the trade risks are minimal. Bull put spread is profitable when there is a rise in the stock prices and a time-decay at the same time. If you need a strategy that limits risks and plays by a neutral forecast, bull put spread is the one.
Bear put spread
This is a type of vertical-spread that involves purchasing a put and hoping that there will be a decline in the stock market. A bear put spread offsets its cost by writing for another put with the same expiry date as the first but with a much lesser strike price.
Conclusion
Been informed and cautious about which vertical spread is suitable at what point is very important. A thorough study of the market situation and the right spread strategy will lead you to a successful trade.