Why buy a vertical spread if I could instead buy a naked call?

Question

If I believe a stock will go up, say from a price of $100, and I wish to execute an options strategy that would make me money if the stock were to rise, why would I want to setup a vertical spread when I could instead purchase a single naked call?

It seems to me that my transaction costs would be 2x with the spread, and while I see that time decay ( Theta ) is mitigated with a vertical spread, wouldn't the unbridled upside to unlimited theoretical profit of the naked call be better in the long run if this strategy is executed multiple times? Specifically, let's say I have a 50% chance that the stock will go up each time I execute. In that case, why not exercise the naked call each time because there's only one transaction fee?

Am I missing factors that would cause vertical spreads to be much more profitable? And if so, what would drive investors to choose one over the other specifically?

Answer 1

Figured it out. Vertical spreads significantly reduce the amount of "buying power" on the account needed vs. buying / selling pure calls / puts. So even though the transaction fees may more double in some instances, it may be worth it in order to operate with pricier underlying instruments.

Spreads are also considered "defined risk" trades where both the profit and loss are capped per how the spreads are setup. This is compared to single calls / puts where either the upside or the downside can be unlimited. So for times when the expected move is not as pronounced, a spread may be a better fit depending on environment and other factors.

Answer 2

Late to the party, but it's just improving your cost basis in a defined risk trade even further. If you want to put up less risk capital but want to test the waters, this can be one way to do it.

Another could be buying cheap OTM butterflies or financing a further otm option with the basis reduction from the debit spread if you want to gamble a bit further and venture into 15-20 delta positions.

Usually, I am doing debit spreads with a buying atm and selling a couple strikes further otm or at least at the most liquid strikes, but if it's a high flier, it can be disappointing, but a good trade. If you're more of a contrarian in where you buy your calls/puts, it's absolutely a good way to lessen your risk on a calculated bet.

Answer 3

The answer depends on if you are looking at prior to expiration or on an expiration basis.

Prior to expiration:

As the stock rises, both calls appreciate in value but since you are short the upper strike, it acts as a drag on the call spread's gain. The naked long call outperforms the spread to the upside.

The spread costs less and its net delta is less than that of the naked long call so to the downside, the spread outperforms (less loss).

At Expiration

The break even point is the upper strike of the spread plus the premium of the upper strike. Above this price, the naked long call outperforms. Below it, the vertical spread outperforms. An example...

XYZ is $100

$100 call is $5

$105 call is $2

BE is $107

At/above $105, the spread's maximum gain is $2. The naked long $100 call makes $2 at $107 so above $107 the naked long call does better. Below $107 the vertical spread call does better.

Missing factors

Change in implied volatility could change the comparison dramatically. To a lesser degree, so too could a pending dividend.

Answer 4

Question: are you saying that buying a call is better than buying a vertical spread regardless of fees, or only because of fees?

If the former, you are saying that buying a call and selling a vertical spread will always be profitable, which effectively means you're going short an out-of-the-money call.

While that's a good strategy, it doesn't guarantee profit, and will lose money exactly when the vertical spread is a better strategy than buying the call outright.

The most direct answer to your question in comments: if the stock goes down, you lose less money with the vertical spread than you do with a simple call.

In return for this lower risk, you give up gains if the stock goes above the higher calls strike price.

Answer 5

The first spread I ever bought, MOT (which no longer exists), was for a 70/80 call spread. The $70 cost me $4.50 and the $80 sold for $3.00. Therefore my cost on ten contracts was $1500. The options expired when the stock was at about $90. Had I only bought the $70, 20/4.5 = 4.44 or a return of $6667 vs the $10K I got for any close over $80. Of course, at some point, here $100, we'd have a crossover, where the call alone was more profitable.

The spread lowered my breakeven, and of course, capped my potential gain. It's not much effort to look at multiple scenarios to see how a simple call purchase differs from the spread in terms of risk/reward.