If you have a directional view on a stock price, buying a vertical spread might be for you. But deciding on strikes and strike widths requires some thought.
Experienced options traders understand how buying single-leg options and vertical spreads can help you take advantage of directional moves, but with defined risk. And because single-leg options and vertical spreads have a vega component, they can be useful if you have a view on implied volatility.
So let’s say you have a positive directional view on a stock, and you're considering buying a vertical call spread. Does it matter which strikes you choose? Yes, it can. In a big way. In fact, in some vertical spreads, the short leg is so far out-of-the-money (OTM), you might be better off just buying the single-leg option. For more on deciding between vertical spreads and single-leg options, refer to this recent article.
Let’s look at some call spreads on a stock that’s trading for $150. We’ll compare a few spreads of varying widths using four strikes, from the at-the-money (ATM) 150-strike call to the far OTM 165-strike call. The strike price of each call, its theoretical value (TV), and its delta are shown in Table 1 below. We’ll look at an ATM 5-point and 10-point spread, and an OTM 5-point and 10-point spread. How are they different?
Note: When quoting these call spreads, the first strike quoted is the buy side; the second is the sell side. For example, “buying the 150–155 call spread” means you’re buying the 150 strike and selling the 155 strike.
Table 2 gives a breakdown of each spread, its price, the TV of the spread (taken as the difference between the TVs of the strikes), and each spread’s delta (the difference between the individual strikes’ deltas). Table 2 also shows:
The gains and losses in this example do not include transaction costs. Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
Buying the 150–155 spread would give you the lowest breakeven point in the stock. This spread also has the lowest price the stock has to reach ($155) in order to hit its maximum gain if the trade is held until expiration.
But having the lowest breakeven point comes at a cost, which is that the 150–155 call spread offers the lowest maximum dollar return, $1.70 (which is $170, since the options multiplier is 100). Even if you consider that a good return on your premium invested, it pales in comparison to the $9.05 ($905 per spread) potential of the 155–165 call spread. But to get there, the stock has to rally an additional $10 by expiration.
And let’s not forget: if the stock goes down between now and expiration, no matter which spread you buy, you’ll lose the entire premium, plus transaction costs.
Let’s throw in some Goldilocks wisdom and look at the ’tweeners. Both the 150–160 and the 155–160 have higher potential returns than the 150–155, with lower max price points for the stock than what the 155–165 requires. The point is, choosing your strike prices comes down to what you expect the stock to do, and when.
And one final note on strike selection—be practical. For example, if the short strike of your vertical spread has very little premium in it, it might be more appropriate to just buy the long strike as a single leg and skip the vertical. It’s all about the risk versus the potential reward.
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