Many investors and traders venturing into the world of options begin by learning about single-legged options strategies. With education, persistence and some hands-on learning, they might even start considering that buying and selling single options is their ‘bread-and-butter’ trading strategy. Bearish stance? Long put. Bullish stance? Long call. These basic strategies can help new options traders understand the benefits that single options trading strategies can offer, such as risk management, leverage, and the potential to generate income, as well as the risks which include the potential to lose the entire amount invested in the option. But the next major milestone (or, wakeup call, for some) is the moment they realize that long single options may not always be the most capital-efficient method to pursue.
Enter… vertical spreads. Don’t let the name intimidate you - this risk-defined options strategy is just one step up (well, actually a ‘leg up’, if we’re getting technical) from the oft-beloved, entry-level long call or put. This type of “entry-level spread”, if you will, is simply the selling of an option at the same time that we buy an option. Why would we do such a thing?
Most options traders understand that a good strategy is one that offers favorable odds, and favorable odds typically begin with an assessment of the risks of a particular trade against the potential reward. And depending on the target price you’ve set on a stock you’re trading, a “vertical spread” might allow you to be more capital efficient as you pursue your trading objectives.
First, the basics, and then we’ll follow with an example. A long vertical call spread (bullish bias) is simply the purchase of a call option on a stock and the sale of a higher-strike call with the same expiration. So, for example, if a stock is trading at $130, you could buy the 135 strike call and sell the 140 strike call as a spread.
A long vertical put spread (bearish bias) would involve buying a put and selling a lower-strike put with the same expiration, so if a stock is trading at $130, you could buy the 125 strike put and sell the 120 strike put as a spread.
It’s worth noting, however, that transaction costs are higher with spreads than with single-leg options. However, since your risk with both the single leg strategy and the long vertical spread strategy is limited to premium paid, plus transaction costs, the vertical spread may represent a more cost-effective way to pursue your trading objectives, because, the premium you collect from your short strike can help offset some of the premium paid for your long strike. The difference, as we will see, is that you limit your potential upside with the spread.
So let's compare. Figure 1 shows an example of a typical options chain. The underlying stock is trading at $131.55, and the options expiring in April 2017 have 71 days until expiration. Suppose you have set a short term price target of $140 for the stock. Would you rather buy the 135 call at its fair value of 2.22, or the 135-140 call spread at its midpoint of 1.31? It’s important to note that the multiplier for listed U.S. equity options is 100, because each standard equity option contract represents 100 shares of the underlying. So, in dollar terms, the total premium for the 135 call is $222 and for the call spread it would be $131 plus transaction costs.
The images below show the expiration payout graphs for the two choices. Note that if the underlying stock is trading at your target price of $140 on the day the options expire, had you bought the 135 call, your payoff would be ($140 minus the strike of $135, minus the $2.22 premium paid), times 100 = $278, minus transaction costs. However, with the call spread, your payoff would be ($140 minus the strike of $135, minus the $1.31 premium paid), times 100 = $369, minus transaction costs.
Of course, with the call spread, an expiration date price of $140 in the underlying stock would be the point at which you would receive the maximum payoff potential, but had you instead just purchased the 135 call outright, your upside potential would continue if the underlying stock rose higher than $140. For example, if the stock finished at $142 at expiration, had you bought the 135 call, your payoff would be ($142 minus the strike of $135, minus the $2.22 premium paid), times 100 shares = $478, minus transaction costs.
But again, as an options trader, would you have ridden this trade all the way to $142, or would you have looked for an exit point along the way? Remember, we began this example by supposing you had a target price in the stock of $140. So if $140 was indeed your target, and thus your exit point, the vertical spread would have allowed you to catch the entire move to $140, but at a lower entry cost.
And if the stock stayed at $130, or went down? In each case, you would have lost your entire premium, plus transaction costs. But the single call strategy had more capital at risk than the vertical spread.