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Why do some in-the-money (ITM) verticals such as the bull call spread trade at less than parity before expiration? Intuitively, with its protective value, isn’t this a better deal than holding long stock if bullish on the underlying, or am I missing something?

Limited risk is a nice feature of bull call spreads, or all verticals, for that matter. It’s also a double-edged sword that helps explain the greater relative worth of certain ITM bull call spreads at expiration, versus when time is still on the clock.

Ask yourself: Would you be willing to pay parity for a bull call spread prior to expiration? Let’s say shares of XYZ are stationed at 66 and there are two weeks left for the July contract. Would the 60/65 call vertical be enticing for $5.00 per spread? How about if shares were at 70 or even 75? If you answered “If I were a seller,” you’re halfway to understanding your own question.

In each instance and the spread maxed out as far as profit potential goes, there is no incentive for a buyer to purchase the vertical as there’s only risk of $5 per spread. But what about an ITM spread where shares are still trading between the strikes? That depends on where the underlying is in relation to the vertical.

A rule is when the underlying is trading above the midpoint of the bull call spread, the pricing will reflect a situation of “less than parity” like you described. This is due to the important relationship of extrinsic or time value potential in both options, which brings us back to the double-edged sword aspect of verticals.

Using the 60/65 call vertical again, let’s say XYZ is at 64 and firmly beyond the midpoint of 62.5. Again, what would you pay? If you said more than $4.00 or its expiration parity value, you’re not appreciating the fact that the short contract, while holding no intrinsic value, will maintain more extrinsic value than the ITM 60 strike call if implieds allow for the presence of time premium. In fact, the lower strike call may trade for parity if implieds are low enough so the 60 strike put is effectively offered with no bid. So if the deep call trades for $4.00 or parity and the 65 call is fetching $0.40 in the open market, the spread’s fair or market value is $3.60.

This spread value reflects the benefit of having sold time premium and thus giving the bull call spread the illusion of a discount to the share price of 64. At expiration and all else being equal, the vertical will expand to $4.00 as the 60 call is still worth $4.00, but the short contract will be worthless, netting the bull call trader $0.40 per spread.

The downside of this below-parity bargain is, as emphasized here, unlike a long call position or long stock, the profit potential of a vertical is capped. The closer to this dollar figure we pay, the less that can be made and the more that’s at risk.

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