Learn/ Options/ Lesson 06

Options · Lesson 06 10 min read Intermediate

Vertical spreads

Capping your gain on purpose sounds like a strange thing to do. What you get for it is a cheaper position, a slower clock and a known worst case — and once the payoff is drawn, the trade becomes obvious rather than clever.

What a vertical is

Two legs, same expiry, different strikes, opposite directions. Buy the 100 call, sell the 106 call. That is a bull call spread, and it is the whole construction.

The money you receive for the leg you sold reduces what the position costs. In exchange, you have handed away everything above the higher strike.

Before: the bare callIllustrative
Uncapped on the right, flat on the left. You paid 4, and the position needs 104 just to break even.
After: the same view, as a spreadIllustrative
Both ends now flat. Cost falls from 4 to 2.3, breakeven improves from 104 to 102.3, and the gain stops growing at 106. Three changes from one decision.

What the cap buys you

Four things, and it is worth being precise about each because the trade-off is genuinely even.

  • A lower cost. The premium collected offsets the premium paid. Here, roughly 40% cheaper.
  • A closer breakeven. This is the most underrated part. The bare call needed a 4% move to break even. The spread needs 2.3%. You are right at a lower bar.
  • A smaller maximum loss. The worst case falls from 4 to 2.3, in rupees, known on day one.
  • A slower clock. You are paying decay on the long leg and collecting it on the short one, so the net bleed is far gentler.

What you give up is only the part above the short strike. If you were expecting a 3% move, that part was never in your forecast anyway.

A spread is not a hedged call. It is a bet with an opinion about how far attached to it — and stating that opinion is what makes it cheaper.

What you gave awayIllustrative
The move keeps going past the short strike. Everything above that line belongs to whoever bought the option you sold. That is the price of the discount, and you agreed to it when you opened the position.

What it does to the greeks

Every greek shrinks, because the two legs partly cancel.

  • Delta is the difference between the two legs' deltas, so a spread responds less to the underlying than a bare option. Slower to make money, slower to lose it.
  • Theta nets off substantially. You still pay decay, but a fraction of what the bare call costs — which is why spreads survive sideways days that would quietly destroy a long option.
  • Vega largely cancels. This is the quiet advantage: a spread is far less exposed to an IV collapse, which makes it a much more honest way to express a view around a known event.

Choosing the width

The distance between the strikes is the one real decision, and it maps directly onto how far you think the move will go.

The same lower strike, eighteen points wideIllustrative
Compare with the narrow version above. Maximum gain is far larger — and so is the cost, and so is the maximum loss, and breakeven has moved further away. Nothing was given free; the shape simply stretched.
  • Narrow. Cheap, near breakeven, small maximum gain. Suits a modest move you are fairly confident about.
  • Wide. Costs more, breakeven further out, larger maximum gain. Suits a big move you are less sure of.

Put the short strike where you genuinely think the move runs out — not at whatever strike happens to make the diagram look best.

Common mistake

Comparing two spreads on maximum gain alone. It is the least likely outcome on the diagram and therefore the least informative number on it. Compare breakevens and maximum losses first — those are the parts of the picture you will actually meet.

Read it yourself

Use the narrow spread: long 100 call, short 106 call, net premium 2.3.

Practice
  1. Underlying finishes at 98. What is the outcome?
  2. Underlying finishes at 120. What is the outcome, and what would the bare call have made?
  3. The underlying does not move for two weeks. Which position is in more trouble — the spread or the bare call?
Show answers

1. A loss of 2.3, the full premium. Anywhere below 100 gives the same answer — the left side is flat.

2. The spread makes 3.7 — the six-point width less the 2.3 paid. The bare call would have made 16. This is the cost of the cap, in full view, and it only bites when the move goes much further than you expected.

3. The bare call, by a wide margin. It carries the full theta of a long option. The spread is paying decay on one leg and collecting it on the other, so a fortnight of nothing costs it a fraction as much. Sideways is the condition that quietly kills long options, and it is exactly the condition a spread is built to survive.

Terms used

Vertical spread
Two legs, same expiry, different strikes, opposite directions.
Debit spread
One that costs money to open — you pay more than you collect.
Credit spread
One that pays you to open. Same shape, opposite side.
Width
Distance between the strikes. Sets both maximum gain and cost.
Short strike
The leg you sold. Where the gain stops growing.

Practise this on your own charts

The Options track works through 7 lessons like this one, each built around a drawn example and an exercise you complete yourself.

See the Options track