Spread Trading: The Versatile Vertical Spread

How a Spread Trader Uses Verticals

Now a spread trader might have approached this situation differently.

He could buy the 55 call for $3.18 and simultaneously sell the 60 call for $1.37, resulting in a net debit of $1.81. That's a reduction of 43% in the trader's net outlay. If the stock stays at $55, he still loses the entire debit, but it's still 43% less than what he would have lost on the call. Also, the breakeven point is now lowered to $56.81 versus $58.18 for the lonely call.

So what's the problem? Why would anyone just buy a call?

Like everything else regarding options trading, there's a trade-off. To get this reduced cost and lower breakeven point, you're giving up the unlimited potential of the call purchase. No matter how high the stock goes, the value of the spread can never exceed $5.

Consequently, since we paid $1.81 for the spread, the maximum profit that can be made is $5 – $1.81 = $3.19. For example, with the stock at $63 the 55 call = $8, the 60 call = $3, and the spread is worth $5. With the stock at $75, the 55 call = $20, the 60 call = $15, and the spread is still worth $5.

Puts vs. Calls

Suppose now that we were to construct this same bull spread using puts. We could sell the 60 put for $6.08 and buy the 55 put for $2.92, yielding a net credit of $3.16. If XYZ is above $60 at expiration, both puts will expire worthless, so the spread will also be worthless and we get to keep the credit of $3.16.

If XYZ is below $55 at expiration, let's say $52, then the 60 put will be worth $8, and the 55 put $3, and therefore the spread will be worth $5. Since we sold it for $3.16 and now we have to buy it back for $5, we end up with a net loss of $5 - $3.16 = $1.84. This will be the amount of loss for any stock price less than or equal to $55 at expiration.

Notice that when we constructed the bull vertical with calls (for a debit), the maximum gain was $3.19 and the maximum loss was $1.81. When constructed with puts (for a credit), the maximum gain was $3.16 and the maximum loss was $1.84. So assuming that you could do the bull vertical with either puts or calls for the amounts shown, which would be a more profitable spread?

Think about it. OK, drum roll please ...

The answer is that they would have exactly the same profit or loss, regardless of where the stock ended up at expiration. While it may appear that the debit spread is better since you can gain more and lose less, the difference (3 cents in this case) is actually an interest adjustment reflecting the fact that in one case (the debit) money is leaving the account, and in the other (credit), money is coming into the account and would be earning interest.

That difference is calculated by multiplying the maximum value of the spread ($5), by the risk-free rate of return (assumed to be 5%) in this example, for the number of days until expiration, or: 5 x .05 x 35/365 = .03.

I'm not going to go into the actual proof, but for those of you who need to be convinced, I'll tell you that it's easy to prove using the put-call parity equation that is discussed at length in Demystifying Call-Put Parity.

The real key to understanding the difference between the two spreads discussed above is to realize that they are synthetically equivalent. Also, you must know how to compare them to each other.

For example, if I could buy the bull call vertical for less than $1.81, that would be a good buy relative to receiving a credit of $3.16 for the bull put vertical. Likewise, if I could sell the bull put vertical for more than $3.16, that would be a good sale relative to buying the bull call vertical for $1.81.

While the examples I've shown generally relate to bull vertical spreads, the concept is exactly the same for bear vertical spreads. It would probably help your understanding, if you ran some bear vertical scenarios using the theoretical values in the above table.