Vertical spread options
Vertical spreads are a combination of long and short calls or long and short puts in the same expiration. To set up a long call spread, you would buy a lower strike call and sell a higher strike call against it. The main advantage of this strategy is that the sale of the upside call can significantly reduce the initial premium outlay when putting on the trade. However, the sale of this upside call also caps the profit potential of the trade. You shouldn’t participate in any move above the short call strike.
When using the measured move target, always be sure to sell the strike closest to the target. This is the level the market is implying the underlying can reach, thus where you would want to set up for point of maximum profit.
Example: We buy the E-mini Aug. 9 weekly vertical spread of 1715-1720 for 0.90. The trader is buying the 1715 calls and selling the 1720 calls for a 0.90 net debit. The risk is $45 per one-lot. The potential reward is $205 per one-lot. Breakeven is 1715.90.
To take a bearish view on the market, a trader could use a vertical put spread. This involves buying a low strike put while selling a lower strike put. As with the long call vertical, a long put vertical is established for a lower initial premium outlay but has a capped profit potential. Again, look to sell the strike closest to the downside measured move target.
Example: We buy the E-mini Aug 9 weekly vertical spread of 1685-1680 for 0.85. This involves buying the 1685 puts while selling the 1680 puts for a 0.85 net debit. The risk is $42.50 per one-lot. The potential reward is $207.50 per one-lot. The breakeven is 1684.15.
Both of these strategies set up for well-defined reward-to-risk ratios and carry less risk than outright calls or puts. The muted effect that implied volatility changes have on these positions is also a factor that makes them particularly attractive around catalyst events.