If you're a trader that participates in any investment, you'll know that one of the most important concepts to understand is the concept of vertical spreads.
Getting into this offer can be tricky, but this article will break it all down for you!
What Is A Vertical Spread?
It is a strategy where an investor buys and sells options with different strike prices to take advantage! This strategy seeks to profit from the volatility changes of the core security.
Types Of Vertical Spreads
● Vertical Call Spread - A vertical call spread involves purchasing a call option and selling a higher strike out-of-the-money call option with the same expiration. This strategy aims to profit from volatility as the underlying stock rises and falls in volatility.
● Vertical Put Spread - In this strategy, you buy a far out-of-the-money put option and sell another put option at the same expiration.
Credit And Debit Spreads
A credit spread involves paying two different prices for the same asset. A debit spread consists of transferring an asset from one account to another account.
Vertical spreads are a type of credit spread.
Which Vertical Spreads To Use
The goal of a vertical spread is to make money through volatility. Since this strategy can work in different conditions, this type of spread is appropriate for nearly any situation.
The only thing you should take into account when deciding which one to use is how much you want to risk. You need to be sure that the potential return outweighs the amount you are risking.
To understand which vertical spread is proper for you, you first need to know how the underlying security (stock or ETF) behaves and its volatility.
You also need to understand how your portfolio is set up. Because each one has different risk- reward ratios like any other trade, it is vital to consider all of these factors when choosing an option strategy that works best for your situation.
Factors To Consider For Vertical Spreads
● Changes in the underlying security can change its volatility: After you've chosen which vertical spreads to use, it is essential to know how the option's prices will react when these changes occur.
● The amount of time left before the expiration: As the expiration date nears, the value of an option will become more volatile.
● The relationship between the strike price and market price: Options with a tremendous difference between their strike prices and their underlying security's current price are more likely to have higher volatility levels.
According to tastytrade, "although implied volatility contributes more of a role with naked choices, it still does influence vertical spreads."
Which Strike Prices To Choose
Since this strategy is focused on volatility, you should choose strike prices that are significantly different. The further apart the strike prices are, the greater the chance that there will be a significant difference in their prices.
It is important to note that many brokers have special requirements for this type of spread. Most brokers limit vertical spreads to 25% of the primary security's existing price or the asking price, whichever is lower.
Vertical Spread Conclusion
Understanding how to use vertical spreads can be essential in creating a more successful investment portfolio. You need to know how each underlying security will behave when volatility changes and how your investing portfolio is set up.
