One of the main advantages of trading in options is that instead of a profit and loss in a straight line that happens with futures, they can be modified to fit in with the risk and reward profile of the trader. There are numerous combinations of options strategies that can be achieved by looking at the options chain. Naturally, traders tend to gravitate towards finding the best vertical spread strategy according to their needs. The vertical spread has multiple kinds of strategies under it. The most prominent are bear put spreads, and bull call spreads. The latter is a stock market strategy where a person purchases a call option and sells another one at a higher strike price. The net premium outflow decreases to the limit of the premium of the sold options. But the trade risk also declines as the trader now has less to lose. But the trader must also remember that although it is one of the best vertical spread strategies, it gives a limited upside compared to a usual long call.

Each trader's risk and reward requirements differ in the financial markets. In this article, we will find out why the vertical spread is a great stock market strategy and how you can use it to your favor in scenarios where the long call is not preferred. The same concept can be applied to a bear put spread compared to a long put.

Factors to Choose the Best Vertical Spread Strategy

A major input for choosing any stock market strategy is based on time. If the time frame for any prediction is not more than a week, then it is preferable to go with a long call. But if the prediction has been made for a long period, traders should try to go with the best vertical spread strategy to get good returns. The best vertical spread strategy can lead to improvements in the pay-off in terms of risk and rewards when the time tends to favor more positional holdings of nearly five days. This strategy can also be carried out till the expiry of the options. When the financial markets fluctuate greatly, it becomes difficult to find shares that may have a directional move in these situations. A lot of Theta is lost by the traders in predictions of breakouts which do not happen because of the overall structure of the financial markets. In any financial market where there is an absence of momentum, the best vertical spreads can be a better option when compared to purchasing a single option.

Another important factor in choosing the best stock market strategy is finding out the days remaining to the expiry of the instrument. It is a very vital input when choosing an options strategy. You have to make your decision based on how long it will take for the option to expire. After the middle of the expiry, the Theta starts to decline faster. So, it is usually a good idea to go with vertical spread strategies compared to single options contracts. It is also important to remember that when the options are declining very fast in the expiry week, it is a great idea to go with a vertical spread for your trades that will be executed for more than a day.

Long Call Spread (Bullish)

In this strategy, buy an ITM call and sell an OTM call. The long call spread is a risk-defined strategy that is bullish. It is made up of a short and long call on the same asset within the same cycle of expiration. But the strike prices of both are different. The long call strike is lower than the short call strike. This reduces the overall cost and risk of the position while limiting the potential for profit in the long call. In any long call spread, the maximum profit is made when the market during the execution of the trade or the expiration is above or at the short call strike price. In this scenario, the long call would increase in value as much as it can before getting to the short strike. Here, the profits are capped. You would get the maximum loss, also known as the debit paid for the trade in the beginning. This happens if the underlying price is below or at the long call's strike price. In this type of debit spread, the losses are restricted to the net cost of entry to the position. The profits are restricted to the difference between the prices of the strikes minus the debit that has been paid upfront. It is the best vertical spread strategy for a lot of people out there.

Short Call Spread (Bearish)

In this strategy, you sell an OTM call closer to the ATM and buy an OTM call away from the ATM. This strategy is also a risk-defined strategy that is bearish in nature. It consists of long and short calls at varying prices within the same period of expiration. Both the strikes are out of money. But the long call is further away from the stock price than the short strike. This trade helps the trader to get a credit upfront. Suppose the price of the stock declines so that the value of the credit spread declines over time. In that case, the initial credit obtained by the trade is kept as profit at the execution of the trade. In this vertical spread strategy, the maximum profit that can be gained is the credit received upfront by the trader. This will happen if the position expires worthless and out of the money during the expiry. This happens when the asset's price during the execution of the trade or expiration is below or equal to the short call's strike price. On the contrary, you would get the maximum loss if the price is above or equal to the strike price of the long call. In this type of credit spread, the losses are restricted to the difference between the strikes of the call, minus the net premium that is collected in the beginning. The gains are limited to the net premium that is collected.

Long Put Spread (Bearish)

In this strategy, you purchase an ITM put and sell an OTM put. It is a strategy that has defined risk and is bearish. It is created out of a long and short put at different strikes in the same cycle of expiry. The strike price of the short put is lower than the long put, and the value of this vertical spread will grow when there is a decline in the price of the asset. The highest profit to be made in the strategy is when the market price during the execution of the trade or at expiration is below or at the strike price of the short put. But if it is above or equal to the strike price of the long put, you would get the largest permissible loss of the trade. In this spread, the maximum gain that can be made is the difference between the strikes of the puts minus the net premium that has been paid upfront. The losses are restricted to the net premium value that has been paid upfront.

Short Put Spread (Bullish)

In this strategy, you sell an OTM close to the ATM and purchase an OTM away from the ATM. This vertical spread strategy also has defined risk and is bullish in nature. It comprises a short and long put at different strikes but with the same expiry. The strike price of the long put is lower than the short put. The value of this vertical spread will decline when there is an increase in the asset's price. The highest profit in this strategy will happen when the market price at the execution of the trade or expiration is above or at the strike price of the put. But if it is below or equal to the strike price of the long put, you would get the highest permissible loss of the trade in this vertical spread strategy. The maximum gain that can be made is equal to the net premium collected in the beginning. The losses are restricted to the difference between the strikes of the puts minus the net premium collected in the beginning.

Conclusion

In many cases, the traders choose the best vertical spread strategy that is useful for them. They then predict the possible targets of equity and execute the trades. The vertical spread strategies are a great method to trade if the trader is sure that their set target will be the resistance point.