Up to this point, we’ve looked at single-leg options strategies—covered calls and cash-secured puts.
Now, we’re going to shift our focus to two-leg strategies, specifically vertical spreads.
As you know, spreads are strategies that involve combining two or more options legs in a single trade. Many traders use spreads because they’re capital-efficient and can allow traders to define their risk and return. Let’s talk about each of these reasons individually.
First, spreads are capital-efficient because they allow traders to potentially participate in the gains of the underlying without having to put up the capital to invest in the underlying itself (like with covered calls and cash-secured puts). However, they can have substantial transaction costs compared to other basic options trades because of the number of contracts involved. Depending on how they’re constructed, spreads can make long options cheaper if a short option is sold to offset the cost. And they can make short options less capital intensive if a long option is bought to hedge the risk.
Second, certain spread strategies like verticals have defined risk and return potential. To better understand how this works, let’s look at the risk profile for short and long options separately, then see what happens when the two are combined. For this example, we’ll use calls. Take a look at the short call risk profile. When you sell a call option, there’s limited maximum gain with unlimited maximum loss.
Compare that to the risk profile of the long call. As you can see, it has limited maximum loss and unlimited maximum gain.
Now, let’s look at the risk profile when these two strategies are combined—this is a short call vertical, which is one of the strategies we’ll explore in this lesson. Notice that the spread has defined risk and return. Defined risk is appealing to many traders, and spreads allow traders to achieve it in a much more capital-efficient way than single-leg strategies.
Spreads can be complex, but at most brokerage firms, you can actually enter trades for them in a single transaction just like you do with a single option. In other words, you can place a trade for both legs at the same time. However, you still have to pay fees per contract.
Vertical spreads are more capital efficient than cash-secured puts and covered calls because they don’t require the trader to own the underlying or have sufficient cash to cover the short position.