Vertical spreads are created by using options having same expiry but different strike prices.
Further, these can be created either using calls as combination or puts as combination.
These can be further classified as: – Bullish Vertical Spread (Using Calls or Using Puts) – Bearish Vertical Spread (Using Calls or Using Puts)
Bullish Vertical Spread using Calls
A bull spread is created when the underlying view on the market is positive but the trader would also like to reduce his cost on position.
So he takes one long call position with lower strike and sells a call option with higher strike.
As lower strike call will cost More than the premium earned by selling A higher strike call, although the cost of position reduces, the position is still a net cash outflow position to begin with.
Say, for example, a trader is bullish on market, so he decides to go long on 10200 strike call option by paying a premium of 350 and he expects market to not go above 10800, so he shorts a 10800 call option and receives a premium of 140.
Bullish Vertical Spread using Puts
The call on the market is bullish, hence, the trader would like to short a put option.
If prices go up, trader would end up with the premium on sold puts.
However, in case prices go down, the trader would be facing risk of unlimited losses.
In order to put a floor to his downside, he may buy a put option with a lower strike.
While this would reduce his overall upfront premium, benefit would be the embedded insurance against unlimited potential loss on short put. This is a ne t premium receipt strategy.
Let us see this with the help of an example, where the trader goes short in a put option of strike 10800 and receives a premium of 300 and goes long in a put option of strike 10500 and pays a premium of 130:
Bearish Vertical Spread using calls
The trader is bearish on the market and so he shorts a low strike hig h premium call option.
The risk in a naked short call is that if prices rise, losses could be unlimited.
So, to prevent his unlimited losses, he longs a high strike call and pay s a lesser premium. Thus in this strategy, he starts with a net inflow.
Let us see this with the help of an example, where the trader goes Long Call option of strike 10800 and pays a premium of 140 and go es short a call option of strike 10200 and pays a premium of 350 & spot price prevails at 10500 :
