Vertical Spreads
A vertical spread is a strategy that involves one long option position and one short option position. The two options have the same underlying, expiration and type. This is a strategy for eliminating some of the risk associated with purchasing an option. There are two types of vertical spreads:
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Bull vertical spread, which includes
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Debit call spread
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Bear vertical spread, which includes
Here, we'll focus on a vertical call debit spread, where the investor purchases the lower strike call and sells the higher strike call. This is a debit spread since the long lower strike call will have a higher premium than the short higher strike call. This strategy should be employed when the investor is bullish on the underlying.
Example: Revisiting the long call example, with XYZ stock trading or $34 per share, our investor purchases the $35 call for $3. She then sells the $40 call for $1.15. This reduces the risk to $185. The breakeven is also reduced to $36.85. However, the maximum value of the position is now $500, since the short option loses $1 for every dollar the long position gains above $40.