Options spread example
Let’s look at a bullish vertical spread, which you’d use if you thought a market might rise, but wanted to limit your downside if it didn’t. In this scenario, a trader would first buy a call option with a given strike, but also sell another call with a higher strike. Both options would share the same expiry.
Let’s assume that the current price of a stock was 140, and you felt it could rise to 150. As a result, you might buy a call with a strike of 135 for a £9.30 premium (which you pay), and sell a call with a strike of 150 for a £2.50 premium (which you receive).
Your aggregate premium to open these options (and your maximum possible loss) is £6.80 (£9.30 paid minus £2.50 received). The time to expiry for both options is 45 days, and the spread on this strategy is the difference between the two strikes – 15 (150 minus 135).
In a profit scenario, the market moves to or above 150 at expiry. You sell the bought 135 call at a profit that always exceeds, but is limited by, your loss on the sold 150 call. Your maximum profit is calculated by subtracting the aggregate premium (6.80) from the spread width (15), which makes your maximum profit £8.20.
In a loss scenario, the market moves below 135 at expiry. Both options expire worthless, but you gained the £2.50 at which you sold the 150 call – resulting in a smaller loss than if you’d only bought the 135 call. Your maximum loss is simply the premium you paid (9.30), minus the premium you received for selling the 150 call (2.50) which equals a maximum loss of £6.80.
It is worth noting, that the sum of the maximum loss and profit for the strategy is equal to the spread (6.80 + 8.20 = 15).