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Vertical Spread . That is a simple vertical spread, where you’re purchasing one call, and selling another. We can do the same thing on the put side. We can also buy a vertical spread on the put side. Instead of calls, if we believe the stock is going down, we can purchase one put, at a higher strike price, sell a put at a lower strike price. In this case, it’s the 80 75. We call this the Barrish vertical spread. We’re buying puts, and we want to profit when the stock goes down.
In this case, the debit is $2.85, which gives us a profit of $2.15. This is the difference between the strike prices, which is $5 minus the $2.85 that we paid for the vertical spread. That gives us a profit of $2.15, if the stock moves down below $75 on expiration.
We can bring up the dialog box here, for the order confirmation. You can see that the maximum profit is $2.15. Maximum loss is exactly what we paid for the spread – $2.85. The cost of everything is $288.
Whether you’re buying calls or you’re buying puts, the basic vertical spread is the basis for almost all of the trades that we put on. In fact, it’s the basis for the calendar, the iron condor, the double calendar, double diagonals, and the sale of vertical spreads.
You see that we can profit from a vertical spread, when we are buying on the call side, if we’re buying the lower strike price, and selling the higher strike price. We can also do the reverse.
Let’s say, for example, we’re interested in profiting in a different way. We’re interested in collecting a premium on this particular option. If we were to sell a vertical spread, we would profit when prices moved in the opposite direction.
Let me just give you an example of how you would enter that order. The sale of a vertical spread involves the sale of an option, and the purchase of an option, just like a regular vertical spread. The only difference is, instead of buying one at a lower strike price, if we’re doing calls, and selling one at a higher strike price, we reverse the process. We sell one at the lower strike price, and buy the one at the lower strike price.
Instead of going to “Buy vertical,” as we would on a normal vertical spread, we actually go to “Sell vertical.” In this case, what happens is, we receive a credit of $2.15. Because this is a 5 wide strike, and we’re receiving a $2.15 credit, then what is the maximum loss on this position?
The maximum gain is the $2.15 credit that we received when we put this position on. The maximum loss is the difference between the 5 strike and the $2.15 credit that we will receive, which is $2.85. So, the maximum loss is $2.85. The maximum gain is $2.15.
If we bring up the confirmation dialog box, you can see that they have the exact same numbers. The maximum profit is 2.15, or 215, and the maximum loss is $285, which is the difference between the strike prices, minus the credit we receive. We would receive a credit of $215, minus the $3 that we paid for a net credit account, $212.
What is the difference, then? Why would you do this, rather than just buying the vertical spread, as we had in our previous discussion?
In this case, the stock has to move up, in order for us to profit. If the stock stayed exactly the same, at $75.20, then we would lose value on these options. These options would both lose value.
How do we know that? If we look over to the left here, at “intrinsic/extrinsic,” The intrinsic value of the option is $3.75. In other words, there is no actual, intrinsic value in this option. It’s not in the money. It is at the money. This is considered an “at the money” option.
Therefore, the price that you’re paying for this option, is all time-valued. The time-value of an option is the amount of value that that option has. If it were go to expiration and the price remained at $75, there would be no value at all to this option. What we’re doing, is we’re saying, “Okay, if a single contract…” This is a very important concept to understand.
A single call contract gives you the right to purchase 100 shares of stock at the strike price of $75. In other words, you have the right to buy 100 shares at $75. And this went to expiration, which is the 3rd week in June. Why would this option have any value at all to you? You could buy it at $75, but the price of the stock is at $75.
There’s no benefit to you, of owning this option, if the stock is at 75. If the stock is at 80, and you had the right to buy it at $75, then your option would be worth $5 at expiration. Everybody else has to pay $80 for that stock, but you could exercise the option, and purchase the stock for $75, giving you an immediate $5 profit.
That’s the power of options. Options give you the right to buy the stock at a future date.