Let's look at a concrete example of a vertical spread, in this case, a bull call spread.

This strategy is used by traders who expect a moderate increase in the underlying assets price, but want to reduce their upfront premium outlay compared to buying a single call option outright.

Suppose a trader believes a stock currently trading at $50 will rise over the next three months, but is unlikely to exceed $54.

Instead of buying a call option outright, which could be expensive, they decide to implement a bull call spread.

To do this, the trader buys a three month call option with a strike price of $50, paying a premium of $2 80.

At the same time, they sell a three month call option with a strike price of $54, receiving a premium of a dollar 30.

Since they're paying more for the lower strike call than they receive from the higher strike call, the net premium outlay is $1 50.

Now, let's analyze the payoff profiles.

If we did a long call alone, it would provide unlimited upside potential beyond its strike price, allowing the trader to fully benefit if the stock rises sharply.

However, this comes at a cost.

The $2 80 premium represents the initial investment.

The short call alone generates immediate income from the premium received, but creates an obligation to sell the stock at $54 if the price moves above that level.

By combining these positions, the trader reduces their initial premium outlay while still positioning for a moderate price increase.

The breakeven point is at $51 50, the strike of the long call, 50 plus the net premium paid.

If the stock remains below $50 at expiry, both options expire worthless, and the trader loses the $1 50 premium.

If the stock rises to $54 or beyond, the profit is capped at $2 50, which is the difference between the two strike prices, $4 minus the $1 50 premium paid.

This strategy has clear advantages, the trader benefits from a lower cost position compared to buying a single call while also having limited downside risk, losing only the net premium paid.

Additionally, the strategy prevents the trader From overpaying for an expensive call option when they expect only a moderate price increase.

However, there are important considerations since the short call caps, potential gains, the trader gives up any profits beyond $54, meaning they miss out on further upside if the stock rallies significantly.

Additionally, this is not a zero cost strategy.

There is still an initial premium outlay of a dollar 50.