Verticals are an option strategy which can be used during periods of high volatility when the market makers inflate the value of an option’s time value. Verticals can be employed in up or down markets and they can either debit (take money out of) or credit (put money into) your account.
Long verticals are only used when the expectation is the underlying will rise in value as in a bullish market. Short verticals are only used when the expectation is the underlying will drop in value as in a bearish market.
Verticals that debit your account have the potential for more profit but they are also directional. This means they only make money if the underlying moves in the expected direction. Verticals that credit your account won’t make as much money but they have a greater probability of profit because they make money if the underlying moves in the expected direction, stays the same, or even moves against you a little bit.
Based on the education we’ve provide so far, what other option strategy does a vertical that debits your account sound like? It sounds a lot like buying a call option if the expectation is bullish and buying a put option if the expectation is bearish.
And what other option strategy does a vertical that credits your account sound like? It sounds a lot like doing a covered call or selling a cash covered put. These are non-directional strategies that make money as long as the underlying doesn’t move against you that much.
Bull Call spread: Buy lower strike call, sell higher strike call (net debit)
Bear Put spread: Sell higher strike put, buy lower strike put (net credit)
Bull Put spread: Buy higher strike put, sell lower strike put (net debit)
Bear Call: Sell lower strike call, buy higher strike call (net credit)
This can all be confusing when just starting out. To help you keep it all straight, review things in this order:
The long vertical strategy is a great way to increase the odds of having a winning trade especially during periods of high volatility which inflates the time value of an option. When time is expensive, a long vertical strategy can still make great returns on stocks expected to rise in value.
Long verticals are “long” because they are bullish or only used when the expectation is the underlying will rise in value. A long vertical on a call (also known as a bull call spread) debits your account while a long vertical on a put (also known as a bull put spread) credits your account.
Long verticals on calls have a higher profitability if the expected move happens, while long verticals on puts have a higher probability of some profit if the expected move doesn’t happen or isn’t as strong as expected.
A long vertical is a strategy that buys and sells two options of different strike prices but with the same expiration. The expiration chosen depends on the how quickly the stock is expected to rise to the highest strike price.
Here’s a quick recap of how a call option makes money:
XYZ underlying trades at $100
The $100 strike price option costs $5 with a 30 day expiration
If the $100 call is purchased, the price of that option ($5) is immediately debited from the account. The full $5 is what it costs for the 30 days of time. There is no intrinsic value. In other words, this option loses value every day for 30 days and will expire worthless unless the stock rises more than 5% in value.
A long vertical seeks to reduce this risk while increasing the odds of significant profits. A long vertical on a call (bull call spread) increases the profitability of the trade if the stock makes the expected move, while a long vertical on a put (bull put spread) increases the probability of a winning trade at the cost of reduced potential profits.
Long vertical on a call (also known as a Bull Call Spread)
Buying the $100 strike price call gives you the right to buy the stock for $100. Selling the $105 strike price call obligates you to sell the stock at $105. This is a limited risk trade very similar to a covered call. The only risk is the difference between the two strike prices ($5) which is further reduced by the amount of money made when selling the $105 call for $3 ($5 – $3 = $2 total risk).
A long vertical bull call spread reduces the risk of the trade caused by expensive time, but also caps the upside. The maximum profit of $3 is only reached if the underlying rises in value to $105 or higher (-$5 original cost + $3 earned by selling the $105 call = -$2 initial debit from your account + $5 increase in intrinsic value of the $100 option = $3 total profit). The stock only has to raise to $102 for this trade to break even (versus $105 for a straight call purchase).
At first this doesn’t seem that appealing…but think about it this way. A total of $2 was risked on the trade. If that $2 risk turns into a $3 gain, the net gain on the trade equals a 150% return even with a maximum cap to the earnings. This 150% is earned if the underlying only moves enough for the original option to break even. For the original $100 strike price option costing $5 to earn 150%, the underlying would have had to increase in value to $115 within 30 days.
Long vertical on a put (also known as a Bull Put Spread)
Selling the $100 strike price put obligates you to buy the underlying for $100. Buying the $95 strike price put gives you the right to sell the underlying at $95. This is a limited risk trade very similar to a covered call. The only risk is the the amount of money paid for the $95 put ($3).
This trade is profitable if the underlying stays above $98. If the underlying rises to $105, this trade still makes $2. At first this might not seem that appealing. But think about it this way:
A total of $3 was risked on the trade. If the stock goes up, stays the same or even goes down a little bit, this trade will make money whereas the Bull Call Spread only makes money if the underlying moves in the expected direction (up). If the stock stays the same or moves as expected, the full $2 credit (a 67% profit) is kept.
Long vertical strategies are employed when the expectations are the stock will rise in value. They are especially useful as a strategy during periods of high volatility in the underlying such as around earnings announcements.
They can be done in a way that either debits your account or credits your account. The upside to doing a Bull Call Spread (which debits your account) is increased profitability. However the underlying must move in the expected direction to be profitable.
The upside to doing a Bull Put Spread (which credits your account) is increased probability of a profit, even if that profit isn’t as large as that from a Bull Call Spread play. In this scenario, the underlying can go up or stay the same for maximum profits and it will even make money as long as the underlying doesn’t go down too much (in this example less than 2%).
NOTE: See Short Verticals in the Non-Directional Options Strategy for more information about the short vertical strategy.