Option Strategies: Vertical Spreads

Options are traditionally associated with the volatility of an underlying asset and with asymmetric payout profiles. However, when combining two or more of them to create an options strategy, it’s possible to create derivative structures to express a purely directional view on the underlying. What’s more, these structures exhibit symmetric payout characteristics within a certain price range for the underlying.

The simplest examples of these strategies are known as vertical spreads. These are divided into call spreads and put spreads, depending on whether they’re constructed as a portfolio of calls or puts, respectively. Their most important characteristics are the following:

  • They involve an equal amount of long and short options
  • The long and the short options have different strike prices
  • All options in the strategy have the same maturity date

Vertical Call Spreads

A vertical call spread comprises of a long call on an underlying, with a set maturity date and a specific strike price, and a short call on the same underlying, with the same maturity date, but with a higher strike price.

Being long this strategy is typically bullish, as the holder profits from a rising price in the underlying. For that reason, this is also known as a bull call spread. By contrast, shorting this strategy would result in a bear call spread.

As the short leg of the call spread involves a higher strike, it’s worth less than the long call of the structure. Therefore, a bull call spread is a strategy which requires an initial upfront premium to be paid.

The payout profile of a call spread on expiration is show below:

As the chart demonstrates, the call spread’s value increases linearly from the lower strike of the long call up to the higher one of the short call. The highest profit is achieved at the higher strike, and it remains constant beyond that.

In other words, contrary to the unlimited profit potential of a long call, the profit of a long call spread is capped and equal to the difference between the two strikes minus the cost of the strategy. At the same time, the strategy exhibits a limited maximum loss, equal to the initial premium paid.

Vertical Put Spreads

A vertical put spread comprises of a long put on an underlying, with a set maturity date and a specific strike price, and a short put on the same underlying, with the same maturity date, but with a lower strike price.

Being long a vertical put spread is typically bearish, as the spread profits from a decreasing underlying price. It’s thus also known as a bear put spread. Shorting this strategy would, in similar fashion, be called a bull put spread.

The short leg of the put spread involves a lower strike, and is therefore worth less than the long put of the structure. Therefore, a bear put spread demands an initial upfront premium to be paid.

The payout profile of a put spread on expiration is show below:

As the chart shows, the put spread’s value increases linearly with a decreasing price in the underlying, from the higher strike of the long put down to the lower strike of the short put. The highest profit is achieved at the lower strike, below which it remains constant.

Contrary to the unlimited profit potential of a long put, the profit of a long (or bear) put spread is capped, and can be calculated as the difference between the two strikes minus the cost of the strategy. The maximum loss of the strategy is also limited and equal to the initial premium paid.