A vertical spread is constructed by the purchase of a call (or
put) and the sale of a call (or put) in the same stock and in
the same month. The only difference between the two options is
the strike price. For instance, a vertical spread can be
constructed by purchasing the IBM June 55 call while selling the
June IBM 60 call. This trade would be called the IBM June 55 -
60 call spread. Similarly, a purchase of the IBM July 45 put and
sale of the IBM July 60 put would be called the IBM July 45 60
put spread.

The key to the construction of vertical spreads is that you
choose the options that are in the same stock, same month, but
different strikes and in a 1 to 1 ratio. That is, you must
purchase one option for every one you sell or sell one option
for every one you buy.
Value and the Vertical Spread

A vertical spreads maximum value is the difference between the
two strikes. For example, the maximum value of the June 55 60
call spread is $5.00. [60 55] = $5.

Using the June 55 60 call spread example, we will set the date
to June expiration on Friday. On that day, all the June options
will expire and the options will be worth parity, as all of the
extrinsic value will have eroded away.

Where does the spread get its value? Basically, from its two
components - the call (or put) you buy or the call (or put) you
sell. Lets look at the spreads value with a couple of
different closing stock prices. If the stock closes at $55, then
both the 55 strike and the 60 strike will be out of the money
and thus worthless. The value of the spread will be zero as both
options are worth $0. If the stock closes at $57.50, the June 55
calls will be worth $2.50. The June 60 calls will be out of the
money and thus worthless, therefore the spread will be worth
$2.50 (June 55 call $ 2.50 June 60 call $0).

If the stock closes at $60.00, then the June 55 calls will be
worth $5.00. Meanwhile, the June 60 calls will be worth $0. This
means that the spread will be worth $5.00 (June 55 call $ 5.00 -
June 60 call $0). This is the maximum value of the spread. Note
that the maximum value is identical to the difference between
the strikes.

As the stock goes higher, the June 60 call becomes in-the-money
and gains intrinsic value. Now, for every penny that the stock
increases in value, the June 55 calls and June 60 calls gain
value equally, keeping the $5.00 spread between the two strikes
constant. To see this, refer to the Table below.

The difference between the strikes is the maximum value of all
vertical spreads irregardless of the distance between the two
strikes. It does not matter whether the spread is $5.00 wide,
$10.00 wide, $20.00 wide, or even $50.00 wide; its maximum value
is the difference between the two strikes. Further, the vertical
spreads maximum value (the difference between the two strikes)
holds true for vertical put spreads as well as vertical call
spreads. Look at our other example, the July 45 60 put spread.

Again we set time forward to Friday, July expiration. We set the
stock closing price at $60.00. At $60.00, both the July 45 puts
and the July 60 puts will be out of the money and thus
worthless. With both the July 45 puts and July 60 puts
worthless, the spread is also worthless (July 60 put $0 July
45 put $0). If the stock finishes at $52.50, then the July 60
puts will be worth $7.50 while the July 45 puts will still be
worthless. In this scenario the July 45 60 put spread will be
worth $7.50 (July 60 puts $7.50 July 45 puts $0). If the stock
finishes at $45.00, then the July 60 puts will be worth $15.00
while the July 45 puts will be worth $0.

At this level, the spread will be worth $15.00 (July 60 puts
$15.00 July 45 puts $0). This is the maximum value of the
spread. As you can see it is identical to the $15.00 difference
between the strikes. As the stock goes lower, the July 45 puts
become in-the-money and gain intrinsic value. Now, for every
penny that the stock decreases in value, the July 60 puts and
the July 45 puts will gain value equally, keeping the $15.00
spread between the two strikes constant. To see this, refer to
the table below.

As stated, the maximum value of a vertical spread is the
difference between the two strikes while the minimum value of
the spread is, of course, $0. This means that in this strategy,
both the buyer and the seller have a limited, fixed maximum
loss. The buyer can only lose what he spent. So, if the buyer
spent $2.20 to purchase the August 35 40 call spread, the most
he can lose is the $2.20 he spent.

For the seller, the maximum loss is the difference between the
maximum value of the spread (difference between the strikes) and
the amount of money received for the sale of the spread. For
example, if you were to sell the August 35 40 call spread for
$2.20 then your maximum loss will be $2.80. Remember, the
maximum value of the spread is the difference between the two
strikes or $5.00 (40 35).

The difference between the maximum value of the spread ($5.00)
and the amount the seller received for the sale ($2.20) leaves a
$2.80 maximum loss. Below, the chart shows the potential amount
of money, both profit and loss, that can be made or lost by both
the buyer and the seller.

In conclusion, it is important to understand and remember that
vertical spreads have both a limited profit and a limited loss
scenario for both the buyer and the seller.