Vertical Option Spreads: More Baggage Than Benefits?
What is a vertical spread?
A vertical spread is an option strategy in which a trader makes the simultaneous purchase and sale of two options of the same type and expiration dates, but different strike prices. The term vertical describes the relationship between the strike prices while inferring the components to the spread share the same underlying contract.
A horizontal option spread, on the other hand, would consist of options in the same market and strike prices, but different expiration dates.
An example of a vertical spread in the e-mini S&P 500 futures is the purchase of March 2014 1850 call and the sale of an 1900 call. At the end of December, this particular vertical spread could have been bought for 20.00 points in premium, or $1,000 (20 x $50). Simply put, the buyer of the spread is willing to wager $1,000 on the prospects of the S&P 500 being above 1850 at expiration. However, the trader doubts prices will surpass 1900 and, therefore, is willing to reduce the cost of entry and risk by selling a call with a strike price at the noted level for $650 (or $13.00 in premium). Had the trader bought the 1850 call outright, the cost would have been about $1,650.