The Complete Book of Option Spreads and Combinations: Strategies for Income Generation, Directional Moves, and Risk Reduction, + Website

CHAPTER 3

Vertical Spreads

Vertical spreads are just about the simplest option spread imaginable. A vertical spread is constructed by buying one option and selling an option that is identical to the first option except for the strike price. It might be easier to think of a vertical spread as a “strike spread” since the strike is the only difference between the two options; the underlying asset, type (put or call), and expiration date are the same. To make certain the trade is a true spread, as opposed to a combination, we’re long one option and short the other.

We begin with vertical spreads because they are, simply said, a necessary tool for option traders. Whether long or short a vertical spread, both risk and reward are defined, so selling vertical spreads (we’ll define what we mean by selling a vertical spread later in this chapter) is a great way to get a payoff that is much like selling an outright option while defining risk. If you’re inclined to sell options, and it’s not a covered call or a cash-secured put, then selling a vertical spread is preferable because you have reduced your risk to a tiny fraction of what it would be if you were naked short an outright option.

Vertical spreads will also become important elements in other combinations when we replace an outright option with a vertical spread in order to improve a strategy. For example, if you wanted to sell a covered call but also wanted to participate to the upside if there’s a really big move from, say, a ...