Lessons from the Pros

Vertical Spreads: Part I

This article is the first one in a series of five newsletters on the topic of vertical spreads. It will introduce the concept of the vertical spread and define its four main components. The subsequent newsletters are going to deal with individual vertical spread strategies, one vertical spread per article.

Let me start with the working definition of what a vertical spread actually is. It is a trade in which the simultaneous buying and selling of the same class option is performed on the same underlying. It could be done with either puts or calls, but not both together. Besides having the same options class for the sold and bought options, two more fine distinctions also must be made. First, verticals must be done on the same month of expiry as well as on the same underlying as mentioned above. Secondly, verticals involve the selection of different strike prices. Hence, Figure 1 visually represents the four components mentioned above. For simplicity’s sake, I have used only two words for distinctions within each of the four categories: Different and same.

The first three categories (Underlying, Option Class, & 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.

However, North Americans love choices, and options on equities are simply just that; CHOICES. Some students apply creative thinking in my class, and start wondering what-if. For instance, I was asked the question: 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?

I love thinking outside of the box; hence, I love to entertain answers to these questions in my class emphasizing what the outcome would be. The figure below uses the same four components which were used to describe the basics of verticals, yet two components are changed – the bold ones.

What the students were describing would look like what is laid out in Figure 2. Two components from the vertical spread have reversed their places: (2) the Option Class is now different and (4) the Strike prices are now the same. If a trader buys a call ATM (at the money) and sells a put ATM, 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 bottomline is that changing any of these four components would create a completely new option strategy. Therefore, for simplicity’s sake in this newsletter, I will stay on the topic of verticals and will not change any of the first 3 components: (1) Underlying, (2) Option Class, and (3) Month of Expiry. I am covering only verticals and my primary focus is on the fourth component, the Strike Prices. Hence, I will again focus on the same figure – Figure 1 which is simply copied one more time to emphasize the point of what verticals are:

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. Figure 4 below visually represents four possible choices. Due to the scope of this newsletter, I will address each of these four in subsequent newsletters.

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. As my (Option Newsletter) predecessor would say: Know your options.

- Josip Causic