What is a Vertical Spread?

A vertical spread is an options trade in which you buy one option and sell another of the same type, on the same stock and expiry date, at different strike prices. Say a stock trades at $50. You buy a $50 call option for $3 a share and sell a $55 call for $1, so you pay $2 a share. Each contract covers 100 shares, so the trade costs $200. If the stock ends below $50, you lose that $200. If it ends at $55 or higher, you make $300, and no more. Buying the $50 call alone would have cost $300, with no limit on the profit. The spread is cheaper because you sold off the gains above $55.

A vertical spread is two options traded as a pair: you buy one and sell another of the same type, both calls or both puts, on the same stock and expiry date but at different strike prices. Spread here means that pair, not the bid-ask spread. Take a stock at $50. You buy a $50 call for $3 a share and sell a $55 call for $1, so you pay $2 a share, or $200, since each contract covers 100 shares. If the stock ends below $50, both calls expire worthless and you lose the $200. If it ends at $55 or higher, the pair is worth the $5 gap between the strikes, $500 in all, and your profit is $300. In between, you break even at $52. The trade costs less than the $50 call alone because you sold every gain above $55 to the buyer of your $55 call. Paying to open makes this a debit spread, and traders call this one a bull call spread. A spread can also pay you to open it, which makes it a credit spread. On the same stock, you sell a $45 put for $2, buy a $40 put for $0.60, and collect $140. If the stock stays above $45, both puts expire unused and you keep the $140. If it falls below $40, the pair costs you the $500 gap, less the $140 you collected: $360, and never more. Pair a credit spread made of puts with one made of calls, and the result is an iron condor. One risk applies to both kinds: the buyer of the option you sold can use it before expiry, though the option you bought still limits the damage. Either way, you know the most you can lose and the most you can make before you place the trade.

A vertical spread is two options traded as one: you pay a little now for gains that stop at a cap. Football clubs strike the same kind of deal when they sell a player. Say a club selling a young striker agrees to take $2M less up front in exchange for add-ons: $1M for every goal he scores next season beyond 10, up to 15 goals. At 10 goals or fewer, the club has simply given up $2M. At 15 or more, it collects the full $5M and is $3M ahead. The goals are the stock price, 10 and 15 are the two strike prices, and the $2M is the price of the spread. That price stayed low because of the cap: without it, the add-ons would have cost the club far more than $2M. Where the picture breaks: a spread can be sold at any moment at the market's price, while the club waits for the season to end.