“Vertical Spreads” involve buying (selling) a higher strike price option and selling (buying) a lower strike price option and can be executed with either Calls or Puts.

• If a trader sells the lower strike CALL option and buys the higher strike CALL option, they would receive a CREDIT (the lower strike Call will trade at a higher price than the higher strike Call) for that trade. Selling the higher strike and buying the lower strike CALL would result in a DEBIT. The opposite is true if the trader executed a PUT spread.

These spreads are known as “risk defined” strategies because the max potential profit and loss is known to the trader at the time of execution.

If we hold all other variables constant, Call and Put Vertical spreads represent a bullish or bearish view on the price of the underlying instrument:

• Long (debit) Call spreads and Short (credit) Put spreads represent a bullish view
• Short (credit) Call spreads and Long (debit) Put spreads represent a bearish view

Of course, as with most options strategies, several factors, including volatility, can also impact the value of vertical spreads, as we’ll demonstrate below.

EXAMPLE:

Let’s look at a real-life example using E-mini S&P 500 options:

Using markets from 4/25 @ 10:35 AM CST, we selected the following options:

Futures: 5,038

Sell 1 5,090 Call | Premium 58.25 | IV: 14.3% | Delta: -.41 | Gamma: -.0019 | Vega: -550.8 | Theta: 1.35

Buy 1 5,130 Call | Premium 42.0 | IV: 13.9% | Delta: .33 | Gamma: .0018 | Vega: 513.8 | Theta: -1.23

Position: Delta: -.08 | Gamma: -.0001 | Vega: -37 | Theta: .12

Max profit and loss (excluding all fees and commissions):

• The max profit that this position could realize is the credit taken in at execution
  • 58.25-42.0 = 16.25 pts (16.25*$50 = $812.50)
• The max loss that this position could realize is the credit taken in minus the difference between the strike prices
  • 16.25-40.00 = 23.75 pts (23.75*$50 = $1,187.50)
• The P&L graph of each option and the overall P&L is shown in the TOP image below

Short 5090 Call (Blue Line)

• 58.25 points were collected at execution on the 5090 Call. At any price below 5090 at expiry, this option is worthless and the trader will keep the premium collected (58.25).
• As the price rises above 5090, the option gains value incrementally which, because this position is short, has a negative impact on the P&L.

Long 5130 Call (Orange Line)

• 42 points were paid at the execution of the 5130 Call. This option, at expiry, is worthless at any futures price at, or under, 5130.
• Similar to the 5090, as the price rises above 5130, the option gains value incrementally, which, in this case, has a positive impact on the P&L.

Position P&L

• They gray line represents the overall P&L of the position at expiration, based on the futures price on the X-axis. This is simply the addition of the value of the blue and orange lines.

P&L Scenarios Prior to Expiration

However, though the max profit and loss is defined at the entry point of the trade, as we mentioned earlier, because option pricing is multi-dimensional, factors like volatility and time can impact the value of the position between execution and expiration. Although it is impossible to illustrate all the different values at which this option could theoretically trade because of the dynamic nature of options pricing, we wanted to illustrate some “what-if” scenarios to demonstrate how things like implied volatility and time decay might impact the position. These are illustrated in the bottom image below.