Understanding Vertical Spreads



How to limit the risk with Long and Short Options Legs?

Basically, a spread is a simple concept of a combination of two legs (one short and one long), but not certainly in that order. To start with, spread will be discussed on how it works and what markets work best with the available spread constructions. Keep in mind the changing risk profiles of a spread in the view point of the position Greeks.

An opposing dynamic occurs when both sides of an option trade were taken in the form of a spread. With the use of a short option reward, the long option risk is counterbalanced and vice versa. If you were to buy an out-of the-money call option on IBM and then make a sell further out-of-the-money call option, a vertical call spread will be created. A vertical call spread is less risky compared to an outright long call.  

When options were combined in this way, you have what is called as a positive position Delta trade. Option spreads which are net short the market are called negative position Delta.

If IBM traded lower, for instance, you’ll be losing on the long OTM call option and will see results on the short FOTM call option. However, the gain/loss values will not be the same. A different rate of change in the option prices will occur. For example, they will not change by an equal amount given the hypothetical decline in shares of IBM, the underlying.

The reason for the different rates of change in the prices of the two legs of the spreads is a simple concept to understand. They are basically an option comprising of different strikes on the call options strike “chain” and, therefore, will involve different Delta values.  

They are options with different strikes on the call options strike "chain" and, therefore, will have different Delta values.

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