Vertical spreads are a popular way for option buyers to lower their cost, and therefore risk. Likewise, they are often used by option sellers to limit risk and margin. Yet, trading vertical spreads might come with more baggage than benefits. Like any other strategy, there is a time and place for vertical spreads, but in my opinion they should not be the staple of a trading portfolio.
What is a vertical spread?
A vertical spread is an option strategy in which a trader makes the simultaneous purchase and sale of two options of the same type and expiration dates, but different strike prices. The term vertical describes the relationship between the strike prices while inferring the components to the spread share the same underlying contract.
A horizontal option spread, on the other hand, would consist of options in the same market and strike prices, but different expiration dates.
An example of a vertical spread in the e-mini S&P 500 futures is the purchase of March 2014 1850 call and the sale of an 1900 call. At the end of December, this particular vertical spread could have been bought for 20.00 points in premium, or $1,000 (20 x $50). Simply put, the buyer of the spread is willing to wager $1,000 on the prospects of the S&P 500 being above 1850 at expiration. However, the trader doubts prices will surpass 1900 and, therefore, is willing to reduce the cost of entry and risk by selling a call with a strike price at the noted level for $650 (or $13.00 in premium). Had the trader bought the 1850 call outright, the cost would have been about $1,650.
The seller of the spread is operating under the opposite premise. He believes the price of the S&P will be below 1850 at expiration, but is willing to purchase insurance to limit the loss should prices exceed 1900. In contrast to the previous trader who sold the 1900 call to finance the cost of the long 1850 call, the seller of the vertical spread purchases the 1900 call to the detriment of his profit potential in exchange for having peace of mind. Should the price exceed 1900, the vertical spread seller will not suffer additional losses.
Calculating the P&L at Expiration
The profit of a vertical spread at expiration is clean cut. The buyer of the spread has the potential to make the difference between the strike price of the long and short options, minus the cost of entering the trade. Using the example above, the trader would be profitable by 30.00 before considering transaction costs, or $1,500 (30 x $50) points if the price of the S&P was above 1900 at expiration. This is figured by subtracting 1850 from 1900, and then factoring in the 20.00 points to enter the vertical spread.
The seller of the spread faces the exact opposite payout profile; he stands to lose 30.00 points should the price be above 1900 at expiration. If the vertical spread expires worthless, he keeps the $1,000 originally collected (of course, this is the premium paid by the buyer). In summary, the maximum potential risk to the spread buyer, $1,000 in this example, is the maximum profit potential to the seller. Not surprisingly, the maximum possible payout to the buyer of the spread, $1,500 in this case, is the maximum loss to the seller.
Calculating P&L Before Expiration
Predicting the profit and loss of a vertical spread at any point before expiration is much more complicated. Before expiration, the spread profit or loss is determined by the widening or narrowing of the difference between the option values on the two legs of the spread. Because the premium of each of the options involved in the spreads are based on factors that cannot be quantified, such as demand, expectations of future volatility, emotion, and timing, the value of a vertical spread before expiration cannot be forecast. In addition, monitoring profit and loss in real time can be a frustrating position due to illogical market participant behavior; later we’ll discuss the potential perils of this type of trading but when trading vertical spreads, being right on market price is only half the battle.
What are the advantages to long vertical spread traders?
The primary advantage to buying a vertical spread, as opposed to an outright option, is the luxury of positioning the trade closer to the market with reduced out of pocket expense. Using the example above, the trader saved about $650 in cost and risk by selling the 1900 call to pay for his long 1850 call. Alternatively, the trader could have opted to buy a call with a distant strike price to keep the cost and risk at $1,000. This could have been accomplished for buying the 1880 call for 20.00 ($1,000). As you can see, the trader would have sacrificed about 30.000 in strike price to achieve the same cost as the vertical spread. Naturally, the odds of the futures price being above 1850 at expiration are much greater than it being above 1900.
What are the pros to short vertical spread traders?
The most notable advantage to trading short vertical spreads is peace of mind. Through the purchase of an option with a distant strike price to protect a sold option, the potential risk of loss is capped at a predetermined level. Accordingly, a short vertical spread provides traders with the assurance that regardless of a catastrophic event the total loss on the trade won’t exceed a certain level.
Trading options outright might be a better strategy
On paper, vertical spreads appear to offer traders the best of all worlds. By nature, it is a limited risk, directional position, with a built in hedge. However, there are two significant draw-backs that sometimes make vertical spread trading a frustrating venture; delta and time.
Delta is simply the pace at which the value of a particular option fluctuates relative to the underlying futures contract.
For example, if an option has a delta of .30 it will gain or lose 30% of a corresponding move in the futures market. Simply, if the S&P goes up 10.00 points, a call option with a delta of .30 should have increased in value by about 3.00. Of course, market pricing is based on emotion just as much as it is mathematics, so the relationship between option value and futures value isn’t always according to theory. Nonetheless, it is important to realize that as a vertical spread trader that at any point before expiration, volatility and time value can interfere with profitability of the trade. It is sometimes necessary to hold the position until expiration to achieve a worthwhile profit. This is particularly true during times of high volatility which has a tendency to neutralize the delta of the trade.
For instance, in highly volatile market conditions it is possible for a trader long a vertical call spread to fail to make gains, or even sustain a loss, despite the market moving in the desired direction. Using the previous example, this can happen if the value of the short 1900 call rises nearly as much as the value of the 1850; some refer to this as a vertical spread handcuff. Such an occurrence is common because speculators often bid up the price of the “cheaper” options with distant strike prices due to affordability. The increased demand for these more affordable strikes often lead to higher percentage gains than options with strike prices closer to the market. Plainly, unless you are planning on holding the trade for a substantial amount of time, vertical spreads might not be the optimal strategy.
Similarly, if time value erosion outpaces the benefits of the underlying market moving in the desired direction, a vertical trader can find himself in a position in which he is losing money despite being “right” in price prediction.
Those trading outright calls and puts, on the other hand, will typically see much quicker profits and losses. They will also have the ability to trade in and out of positions more proactively than a vertical trader would. In summary, vertical spreads are a better “buy and hold” strategy for option traders while outright options are better suited for swing traders. Don’t fall into the fallacy that any type of strategy can be applied in all circumstances; there is a time and place for everything.
*There is substantial risk of loss in trading futures and options; it is not suitable for everyone.
Carley Garner is the Senior Strategist for DeCarley Trading, a division of Zaner, where she also works as a broker. She authors widely distributed e-newsletters; for your free subscription visit www.DeCarleyTrading.com. Her books, “A Trader’s First Book on Commodities,” “Currency Trading in the FOREX and Futures Markets,” and “Commodity Options,” were published by FT Press.