Vertical Option Spread Trading Pros and Cons

 

 

Calculating the P&L of a Vertical Spread AT Expiration

Calculating the profit of a vertical spread at expiration is relatively straight forward.  The buyer of the spread has the potential to make the difference between the strike prices of the long and short options, minus the cost of entering the trade.  For this to occur, the price of the underlying futures contract would have to be beyond the strike price of the sold option.  Using the example above, the trader would be profitable by 25.00 before considering transaction costs, or $1,250 (25 x $50) points if the price of the S&P was above 2125 at expiration.  This is figured by subtracting 2075 from 2125, and then factoring in the 25.00 points to purchase the vertical spread.

The seller of the spread faces the exact opposite payout profile; he stands to lose 25.00 points should the price be above 2125 at expiration.  If the vertical spread expires worthless, he keeps the $1,250 originally collected (of course, this is the premium paid by the buyer).   In summary, the maximum potential risk to the spread buyer, $1,250 in this example, is the maximum profit potential to the seller.  Not surprisingly, the maximum possible payout to the buyer of the spread, $1,250 in this case, is the maximum loss to the seller. In other words, this is a zero sum game.  For every trade there is a sinner and a loser with the exact opposite experience in regard to profit and loss.  This example ignores transaction costs which must be added to the buyer’s cost, and subtracted from the seller’s premium collected.

 

Calculating Vertical Spread P&Ls BEFORE Expiration

Predicting the profit and loss of a vertical spread at any point before expiration is much more complicated; in fact, it is impossible. Before expiration, the spread profit or loss is determined by the widening or narrowing of the difference between the option values on the two legs of the spread.   Because the premium of each of the options involved in the spreads are based on factors that cannot be quantified, such as demand, expectations of future volatility, emotion, and timing; the value of a vertical spread before expiration cannot be forecast.  Any attempt at such is nothing more than an educated guess. 

In addition, monitoring profit and loss of a vertical spread in real time can be frustrating. When trading vertical spread strategies, being right on market price is only half the battle.  We’ll discuss this further in the following sections.

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