Why Vertical Spreads... Vertical Spreads are used to offset premium costs when buying options or to hedge risks when selling options. The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management. While verticals are often considered a more advanced options strategy, the strategy usually has lower risk and a better probability of profit than outright call or put buying.

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Example

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How they win and lose

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Wrap-up

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Example The risk profile of a bull call debit spread or long vertical call spread is shown below. With the stock at 149, the 150 call is purchased for \$10, and to offset some of that cost, the 160 call is sold for 5.90, for a net debit of \$4.10

Shown below is what the risk profile looks like at expiration. The position profits at any price above \$154.10, but the gain is capped if the stock moves beyond 160.

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How They Win and Lose Let’s take a look at an example of a winning position. XYZ price bounces off resistance at the same time that volatility spikes. Since volatility is high we will choose to buy call spreads as opposed to long calls, since the sold option in the spread helps offset the high option premiums.

With the stock at 23.50 and rising in mid-August, we will buy the September 22.50 calls for \$2.00 and sell the 25 calls for \$.85 for a net debit of \$1.15. The maximum risk is the \$115 we paid, realized if the stock is below 22.50. The maximum gain is \$135. In this case, XYZ went up to 26, so the trade worked out perfectly, giving us a 117% return.

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VERTICAL SPREADS Let’s take a look at an example of a losing position. This set-up looks very similar when the trade was put on.

Again, we seem to have the price bottoming out, here in late July with a spike in volatility. The price breaks back above 48 as the volatility starts to fall, so we buy the August 49 call for \$.80 and sell the 50 call for \$.50 for a net debit of \$.30. After a quick move in our direction, the price dives down to below 46. We hold the position and at expiration, we lose the debit we paid of \$30 Impact of Stock Direction This is a directional trade, so the long call spread and short put spread will profit from the stock moving up and lose from the stock moving down. The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management. Impact of Volatility The spread is used to limit exposure to volatility, so changes in volatility will have little effect. Impact of Time Decay Time is against you with a debit spread and for you with a credit spread.

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Wrap-up Vertical spreads provide known and fixed maximum gain and loss They are usually used when volatility and/or premiums are high They can be credit or debit spreads They can increase the probability of profit with directional trades, but limit the upside