This article originally appeared on The Options Insider Web site.
Editor’s note: This is the first of a five-part series on vertical spreads. This article will introduce the concept of the vertical spread and define its four main components, while the next four articles will deal with individual vertical spread strategies.
A vertical spread is a trade in which the simultaneous buying and selling of the same class option (i.e., either puts or calls, but not both together) is performed on the same underlying stock. Verticals must be done on the same expiration month, and they involve the selection of different strike prices.
The table below visually represents the four components mentioned above:
The first three categories (underlying, option class and month of expiry) are easy to comprehend. The buying and selling is done on the same underlying. Either calls or puts are used (not a mix of both). Moreover, the action of buying a put and selling a put (or buying a call and selling a call) is done using the same expiry month. So there is not much variation: same underlying, same option class (calls or puts), and same expiry month. So there is not much variation: same underlying, same option class (calls or puts), and same expiry month.
However, traders love choices, and options on equities are simply just that: choices. One of my students asked what would happen if we buy a call and sell a put at the same strike price on the same underlying and on the same month.
The figure below uses the same four components that were used to describe the basics of verticals, yet two components are changed (the bold ones).
Two components from the vertical spread have reversed their places: The option class is now different and the strike prices are now the same. If a trader buys an at-the-money (ATM) call and sells an ATM put, then the trader has traded the same strike prices using two different option classes. This strategy is known as a synthetic long.
There is also another variation, which would still have the same strike prices and different option classes but an ATM put is bought and an ATM call is sold. This strategy is a synthetic short. These are NOT vertical spreads.
The bottom line is that changing any of these four components would create a completely new option strategy.
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Therefore, for simplicity’s sake, I will stay on the topic of verticals and will not change any of the first three components: underlying, option class and month of expiry. I am covering only verticals and my primary focus is on the fourth component, strike prices.
Here is the earlier table:
When a variation is done by selection of different strike prices on the same underlying, with the same option class and the same month of expiry, then the trader still ends up with more than one choice. However, the starting point should be looking at what is first bought.
For instance, the verticals could be done in such a way that first, an ATM strike price is purchased. Once the purchase is completed, then the next leg could be opened. The trader could choose to sell either one strike price above the bought ATM option, or sell one strike price below the bought ATM option. If the situation is done in such way that the sold option brings more premium in than what was paid out for the bought option, then that is called a vertical credit spread.
If it is the other way around, meaning that more premium was paid out and only part of it was received back for the sold option, then that is called a vertical debit spread.
What makes the verticals even more complex is that the same thing can be done with calls as well as with puts.
The table below visually represents four possible choices. Due to the scope of this article, I will address each of these four in subsequent articles.
In conclusion, the aim of this article was to simply introduce the concept of the vertical spread and to define its four components. A change of any of the four components creates a completely new strategy, yet within each new strategy there could be variations as was explained when verticals were compared to synthetics, which, in turn, could be either long or short synthetics.
Other Articles in This Series:
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