Vertical spreads are a fundamental strategy for option traders, offering a straightforward way to take directional positions. By carefully selecting the spread based on implied volatility and directional bias, traders can effectively manage their risk and capitalize on market movements.

Understanding Vertical Spreads

A vertical spread consists of two options of the same type (either both calls or both puts) with the same expiration date but different exercise prices. The basic structure involves purchasing one option and selling another. Here are typical examples:

  • Call Spread: Buy 1 June 100 call, sell 1 June 105 call.
  • Put Spread: Buy 1 March 85 put, sell 1 March 75 put.

Bull Vertical Spreads

A bull vertical spread is created by buying a lower exercise price option and selling a higher exercise price option, whether using calls or puts. This strategy benefits from an increase in the underlying assets’ price.

How It Works

  • Call Spread Example: Buying a lower strike call and selling a higher strike call. The call with the lower exercise price has a higher delta, resulting in a net positive delta position.
  • Put Spread Example: Buying a lower strike put and selling a higher strike put. The lower strike put has a smaller negative delta, also resulting in a net positive delta position.

Regardless of market changes, a bull vertical spread remains bullish. The maximum value at expiration is the difference between the exercise prices if both options are in-the-money, or zero if both are out-of-the-money.

Example: A trader buys a June 100/105 call spread for $2.25. If the market is above 105 at expiration, the spread is worth $5, yielding a profit of $2.75. Conversely, selling a March 75/85 put spread for $6.50 and seeing the market above 85 at expiration means both puts expire worthless, and the trader keeps the $6.50 profit.

Bear Vertical Spreads

A bear vertical spread involves buying a higher exercise price option and selling a lower exercise price option, again using either calls or puts. This strategy profits from a decline in the underlying asset’s price.

How It Works

  • Call Spread Example: Buying a higher strike call and selling a lower strike call. The higher strike call has a smaller positive delta, resulting in a net negative delta position.
  • Put Spread Example: Buying a higher strike put and selling a lower strike put. The higher strike put has a greater negative delta, also resulting in a net negative delta position.

A bear vertical spread stays bearish irrespective of market conditions. The maximum value at expiration is the difference between the exercise prices if both options are in-the-money, or zero if both are out-of-the-money.

Example: A trader sells a June 100/105 call spread for $2.25. If the market is below 100 at expiration, both calls expire worthless, and the trader keeps the $2.25 profit. Alternatively, buying a March 75/85 put spread for $6.50 and seeing the market below 75 at expiration makes the spread worth $10, resulting in a profit of $3.50.

Determining the Total Delta of Vertical Spreads

The total delta of a vertical spread, influenced by the exercise prices and the number of spreads executed, determines its directional bias. Wider exercise price differences yield a higher delta. For example:

  • A 95/110 bull spread has a higher delta than a 100/110 bull spread, which in turn is higher than a 100/105 bull spread.

Traders adjust their positions based on their confidence and risk tolerance. For instance, to achieve a 1,000-delta position, a trader could either execute a spread with a 50 delta twenty times or a spread with a 25 delta forty times.

The Role of Volatility in Vertical Spreads

Volatility plays a crucial role in choosing the appropriate vertical spread. When options are overpriced due to high implied volatility, the at-the-money option is the most overpriced. Conversely, when implied volatility is low, the at-the-money option is the most underpriced.

Strategy:

  • High Implied Volatility: Focus on selling the at-the-money option.
  • Low Implied Volatility: Focus on buying the at-the-money option.

For example, with the underlying asset at 100:

  • If implied volatility is high, prefer the 95/100 call spread.
  • If implied volatility is low, prefer the 100/105 call spread.

Whether you are bullish or bearish, vertical spreads offer a strategic way to take part in the options market with defined risk and reward parameters. For more in-depth information and advanced strategies, visit the Rival Systems Options Knowledge Base.

Check-out Rival One to see how users leverage advanced features to price and trade option spreads. Whether you’re a seasoned trader or just getting started, Rival One offers the tools you need to succeed in today’s fast-paced markets.

 

This material is meant for educational purposes only. The information, strategies, and examples presented are not to be construed as trading or investment advice. Rival Systems does not endorse or recommend specific trading or investment decisions and users are encouraged to exercise their own judgement and seek professional advice before making any financial decisions.

Users are urged to carefully consider their financial objective, risk tolerance, and level of experience before engaging in trading or investment activities. Rival Systems is not responsible for any inaccuracies, errors, or omissions in the educational content or for any actions taken in reliance on such content.