Understanding Vertical Spread Options and How to Calculate it

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  • 07 Oct 2023
Understanding Vertical Spread Options and How to Calculate it

Using the vertical option spread method, traders can profit from the market's directional bias. In India, the vertical spread is a well-liked trading technique that enables investors to profit from market trends while lowering their risk. In this strategy, a call or put option is bought at one strike price, and a second call or put option is sold at a different strike price and with the same expiration date. In an options chain, the options are piled vertically; hence, "vertical spread."

The bull call spread and the bear put spread, which involve buying a lower strike call option and selling a higher strike call option, or buying a higher strike put option and selling a lower strike put option, respectively, are the two basic varieties of vertical spreads.

It's crucial to remember that the options in the spread must all have the same expiration month since otherwise, the spread would become a calendar spread, which is a separate approach.

Vertical spreads come in a variety of forms. Types of vertical spreads is as follows

1. Bulls

Bull call spreads and bull put spreads are used by bullish traders. The trader purchases the option with the lower strike price and sells the option with the higher strike price for both methods. The time of the cash flows is the primary difference, excluding the distinction in option types. In contrast to the bull put spread, the bull call spread initially results in a net credit.

2. Bears

Bear call spreads or bear put spreads are used by traders who are going bearish. The trader sells the option with the lower strike price and purchases the option with the higher strike price when using these techniques. Here, the bear call spread results in a net credit to the trader's account whereas the bear put spread results in a net negative.

You must take into account the following criteria while calculating the profit and loss for an Indian vertical spreads options strategy:

1. The options' strike prices are: Purchasing and selling options with various strike prices is part of a vertical spreads options strategy.

2. The premium received or paid: When an option is purchased or sold, the premium, which represents the option's price, is paid or received.

3. The options' expiration date is: Options have a set expiration date after which they lose all of their value.

To determine the profit or loss, take the following actions:

Determine the maximum loss:

The difference between the premium paid and received constitutes the maximum loss for a vertical spreads options strategy. Your maximum loss, for instance, would be Rs. 200 if you spent Rs. 500 to buy an option and Rs. 300 to sell another option.

  • Find the breakeven point

The price at which the approach begins to generate a profit is the breakeven point. The strike price of the purchased call option plus the net premium paid represent the bullish call spread's breakeven point. The strike price of the sold put option less the net premium received is where a bearish put spread breaks even.

  • Calculate the profit or loss

The difference between the price of the underlying asset at expiration and the breakeven point must be taken into account when calculating the profit or loss. The approach is profitable if the price of the underlying asset is higher than the breakeven threshold. It loses money if it falls below the breakeven point.

Let's say you paid Rs. 5 in premium to buy a call option with a strike price of Rs. 100 and gained Rs. 2 in premium when you sold a similar call option with a strike price of Rs. 110. The highest loss (the discrepancy between the premium paid and received) would be Rs. 3. The strike price of the purchased call option plus the net premium paid would equal Rs. 103, which would be the breakeven threshold. The profit would be Rs. 7 (the difference between the strike price of the sold call option and the breakeven point, less the net premium paid and received) if the price of the underlying asset at the time of expiration is Rs. 115.

Conclusion

As a relatively low-risk technique that enables traders to profit from market trends while limiting their potential losses, the vertical spreads options strategy is a popular one among traders in India. Open a Demat account with Kotak Securities right away to get started if you want to test out this tactic.

To use this technique successfully, you must first be familiar with options trading and understand the dangers involved, as with any other options trading approach.

FAQs on Vertical Spread Options

The major danger is that the trader could lose money if the options expire worthless. Additionally, the profitability of the approach may be impacted by modifications in the market environment, such as unexpected news or occurrences.

An option trading strategy known as a "vertical spread" entails purchasing and selling options with various strike prices but the same expiration date.

All vertical spreads have specified risk and limited potential for profit that are understood at the time the deal is opened. Bullish trading tactics include bull call and bull put credit spreads.

Price spreads is another name for vertical spreads, which makes sense. Spread refers to a disparity, and the strike prices vary between the two legs. When two contracts have different expiration dates but the same strike price, a horizontal spread is present.

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