Vertical Option Spread Trading Pros and Cons

 

 

What are the benefits of trading long vertical spreads (buying the spread)?

The primary advantage to going long a vertical spread, as opposed to buying an outright option, is the luxury of positioning the trade closer to the current market price with reduced out of pocket expense.  Going back to the aforementioned example, the trader saved about $1,250 in cost and risk by selling the 2125 call to pay for his long 2075 call.   Simply put, the trader was able to purchase the 2075 call for $1,250, rather than the $2,500 price tag.  Of course, there is an opportunity cost to getting a discount. 

Rather than purchasing the 2075/2125 vertical spread, the trader could have opted to simply buy a call outright.  We’ve already determined that the 2075 call would have come with a total cost and risk of $2,500 but it would have also been possible to purchase a call with a distant strike price to cut the cost to the desired $1,250.  In this instance, the March 2125 call could have been purchased for about 25.00 or $1,250.  Thus, the trader faces the same risk and cost of the original vertical spread by simply purchasing the 2125 outright.   As you can see, the trader would have sacrificed about 25 in strike price to achieve the same cost as the vertical spread.  Naturally, the odds of the futures price being above 2075 at expiration are much greater than it being above 2125.  Nevertheless, a buyer of a 2125 call would have potentially unlimited profit potential.

 

What are the pros of trading short vertical spreads (selling the spread)?

The most notable advantage to trading short vertical spreads is peace of mind.  Unlike outright option sellers who face theoretically unlimited risk, vertical spread traders cap their risk at a predetermined level through the purchase of an option with a distant strike price.  Accordingly, a short vertical spread provides traders with the assurance that regardless of a catastrophic event the total loss on the trade won’t exceed a certain level.  In essence, the purchased option acts as insurance to the option seller, but as with most insurance policies, it is often more of a burden to a buyer than a benefit.  

 

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