What Are Vertical Spread Options?

The vertical spread options strategy is a popular options trading strategy used by traders in India and around the world to take advantage of market trends and manage risk. This strategy involves simultaneously buying and selling two options with different strike prices but the same expiration date.

Vertical Spread: Meaning and Definition

A vertical option spread is a strategy that allows traders to take advantage of a directional bias in the market. The vertical spread is a popular trading strategy in India that allows traders to capitalise on market trends while reducing their risk. This approach involves purchasing a call or put option at one strike price and selling another call or put option with a different strike price and the same expiration date. The options are stacked vertically in an options chain, hence the name "vertical spread." 

There are two main types of vertical spreads: the bull call spread and the bear put spread, which respectively involve buying a lower strike call option and selling a higher strike call option, or buying a higher strike put option and selling a lower strike put option.

It's important to note that the options used in the spread must have the same expiration month, as using options with different expiration months would turn the spread into a calendar spread, which is a distinct strategy.

Types of Vertical Spread

Vertical spreads can be either debit spreads or credit spreads. A debit spread involves paying for the spread, while a credit spread involves receiving a credit for the spread. Debit spreads are used in bullish market conditions, while credit spreads are used in bearish market conditions.

Examples of Vertical Spread

The vertical spread options strategy aims to profit from the difference in the premiums of the two options while limiting the potential losses.

Here's a vertical spread options example:

Suppose an investor believes that the stock of a particular company, say XYZ, is going to rise in the short term but wants to limit its downside risk. They can use a bull call spread strategy to capitalise on this opportunity.

Assuming XYZ is currently trading at Rs. 1,000, the investor can do the following:

Buy a call option with a strike price of Rs. 1,020 that expires in 1 month for a premium of Rs. 50 per share.

Simultaneously sell a call option with a strike price of Rs. 1,050 that expires in 1 month for a premium of Rs. 20 per share.

The net premium paid for the vertical spread options strategy is the difference between the premium received from selling the call option with the higher strike price and the premium paid to buy the call option with the lower strike price, which is Rs. 30 per share (Rs. 50 - Rs. 20).

The difference between the strike prices of the two options minus the net premium paid is the maximum potential profit for this strategy. In our example, it is Rs. 1,050 - Rs. 1,020 - Rs. 30 = Rs. 0 per share.

The maximum potential loss for this strategy is the net premium paid, which is Rs. 30 per share.

If the price of XYZ rises and the stock is trading at, say, Rs. 1,100 at the expiration of the options, the investor will make a profit of Rs. 20 per share (the difference between the strike price of the two options minus the net premium paid). However, if the stock falls below Rs. 1,020, the investor will start to incur losses, which will be limited to the net premium paid.

It's important to note that this is just an example, and investors should carefully consider their own risk tolerance and investment goals before implementing any options trading strategy.

Calculating Vertical Spread Profit and Loss

To calculate the profit and loss for a vertical spread options strategy in India, you need to consider the following factors:

• The strike prices of the options:

  A vertical spread options strategy involves buying and selling options with different strike prices.

• The premium paid or received:

  The premium is the price of the option, which is paid or received when the option is bought or sold.

• The expiration date of the options:

  Options have a specific expiration date, after which they expire worthless.

To calculate the profit or loss, follow these steps:

1. Determine the maximum loss:

   The maximum loss for a vertical spread options strategy is the difference between the premium paid and received. For example, if you paid Rs. 500 to buy an option and received Rs. 300 for selling another option, your maximum loss would be Rs. 200.

2. Determine the breakeven point:

   The breakeven point is the price at which the strategy starts to make a profit. The breakeven point for a bullish call spread is the strike price of the bought call option plus the net premium paid. The breakeven point for a bearish put spread is the strike price of the sold put option minus the net premium received.

3. Calculate the profit or loss:

   To calculate the profit or loss, you need to consider the difference between the price of the underlying asset at expiration and the breakeven point. If the price of the underlying asset is above the breakeven point, the strategy makes a profit. If it is below the breakeven point, the strategy incurs a loss.

For example, suppose you bought a call option with a strike price of Rs. 100 and paid a premium of Rs. 5, sold another call option with a strike price of Rs. 110 and received a premium of Rs. 2. The maximum loss would be Rs. 3 (the difference between the premium paid and received). The breakeven point would be Rs. 103 (the strike price of the bought call option plus the net premium paid). If the price of the underlying asset at its time of expiration is Rs. 115, the profit would be Rs. 7 (the difference between the strike price of the sold call option and the breakeven point, minus the net premium paid and received).

Conclusion

The vertical spread options strategy is a popular choice among traders in India because it is a relatively low-risk strategy that allows traders to profit from market trends while limiting their potential losses. If you are willing to experiment with this strategy, open a Demat account with Angel One now and get started.

However, as with any options trading strategy, it is important to understand the risks involved and to have a solid understanding of options trading before using this strategy.

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