‘A complex strategy that caps my potential profits? No thanks.’
But wait, hear us out.
Vertical Options Spreads have this strange reputation of being a lot more complicated than they really are. Because of this, new traders make the mistake of dismissing spreads without taking into account their proper purpose — to minimise risk.
By predefining risk and reward, vertical option spreads can be used to profit from market price increases, decreases and sideways movement. They form the building blocks of more advanced option spread strategies like the Iron Condor, Butterfly, and Back Ratio, to name a few. But before we touch on those advanced strategies, we’ll help you master the basics of vertical options spread.
What are Vertical Option Spreads?
Vertical spreads involve the simultaneous buying and selling of two options (call or put) of the same stock, with the same expiration date, just at different strike prices.
As spreads involve both the buying and selling (or writing) of an option, the theory goes that the proceeds from the sale should offset the purchase of the option. This lowers the cost of the trade overall, while also mitigating the risk involved. Although, the trade-off for minimising risk is the capping of potential gain. Because of this cap on potential profit, vertical spreads are not an appropriate strategy if the underlying stock is expected to breakout into a substantial trend. Rather, vertical spreads are best used when modest price action is expected in the underlying.
One thing that must be considered before putting on a spread, is the risk of early assignment. Remember stock options can be exercised on any business day up until expiration. If early assignment does occur, in most cases the logical thing to do is close the position by exercising the long call. However, additional fees may be applicable and assignment could also trigger a margin call if there is insufficient equity in your account to support the stock position.
Vertical spreads can be separated into two categories: debit spreads and credit spreads.
Vertical Debit Spreads
The setup — Buy high premiums options while selling low premium options, resulting in a debit from the traders account.
The purpose — To reduce premium amount payable.
Examples — Bull Call Spread & Bear Put Spread.
Vertical Credit Spreads
The setup — Sell high premium options while buying a low premium option, resulting in a credit to the trader’s account.
The purpose — To reduce option position’s risk.
Examples — Bear Call Spread & Bull Put Spread
Vertical Spreads v Naked Options
Option writers take on substantial risk to receive a comparatively small amount of option premium. Where traders don’t own the underlying stock, writing naked or uncovered options is one of the most dangerous strategies out there. Selling naked calls carries unlimited potential loss if a trade goes the wrong way. For naked puts, traders could be left holding a large number of unwanted stocks in a market downturn. The consequences of just one bad trade could potentially wipe out all other wins.
Vertical Spreads are much less risky than writing naked options. While they limit the upside profit potential, they predefine and mitigate risk — which is the key to successful longevity trading.
They are also less sensitive to the Greeks. Since option spreads involve one long and one short position, they are affected less by time decay, movement in the underlying price, and changes in volatility.
There a four basic types of vertical spread strategies
Bull Call Spread
The Bull Call Spread also known as Call Debit Spreads, involves simultaneously purchasing a call option and selling a call option of higher strike.
This strategy is used when a trader expects a moderate upside movement rather than huge upward gains. Bull call spreads are also used to reduce the overall cost of the call option, since call options for stocks experiencing elevated volatility are expensive.
If the stock falls and expires below the lower strike price, the option strategy expires worthless.The traders losses will be limited to the net cost involved in purchasing the spread.
If the stock price rises and expires above the higher strike price, the trader exercises their first option and purchases the shares at a lower strike, then sells the shares at the second higher strike price. The trader’s gains are the difference in strike price of the calls less the premium paid for spread. The downside is that if the stock skyrockets upward, the trader forfeits any price moves above the strike price of the sold call option.
If the stock price expires in between the strike prices, the breakeven point will be the higher strike price minus the net premium paid for the position.
Bear Call Spread
The Bear Call Spread also known as Call Credit Spreads, involves simultaneously selling a call option and purchasing a call option of higher strike. This strategy is used when volatility is high and the trader expects a moderate downside or sideways movement of the stock. Selling a stock short carries unlimited risk, therefore bear call spreads can be used to reduce the net risk of the overall call option.
If the stock declines and expires below the lower strike price, both options expire worthless and the trader gets to keep the credit.
If the stock price rises and expires above the higher strike price, the trader exercises their second option and purchases the shares at a higher strike, then sells the shares at the first lower strike. The trader’s loss will be the net cost of the premiums of the call options.
If the stock expires between the strike prices, the breakeven point will be the lower strike price plus the credit received.
Bull Put Spread
The Bull Put Spread also known as Put Credit Spreads, involves simultaneously selling a put option and purchasing a put option of lower strike.
This strategy is used when a trader expects a moderate upside or sideways movement of the stock price until expiration.
If the stock drops and expires below the lower strike price, the short put is assigned and the long put is exercised and the trader’s maximum loss is realised. The loss will be the difference in strike price of the puts less the credit received.
If the stock price rises and expires above the higher strike price, both options expire worthless and the trader gets to keep the credit taken when entering the position.
If the stock price expires in between the strike prices, the breakeven point will be the short put strike minus the credit received for the position.
Bear Put Spread
The Bear Put Spread also known as Put Debit Spreads, involves simultaneously buying a put option and selling a put option of lower strike.
This strategy is used when a trader expects a moderate downside movement of the stock price but not a huge downward trend. Selling the put with the lower strike price also helps offset the cost of purchasing the put option with the higher strike price.
If the stock falls and expires below the lower strike price, the long put is exercised and the short put is assigned, resulting in the stock being purchased at the lower strike and sold at the higher strike. The trader’s gains are the net cost of the premiums of the put options. The downside is that if the stock falls dramatically, the trader forfeits any price moves below the strike price of the lower put option.
If the stock price rises and expires above the higher strike price, the option strategy expires worthless. The trader’s losses will be limited to the amount spent in purchasing the spread.
If the stock price expires in between the strike prices, the breakeven point will be the long put strike minus the premium paid for the position.
Selecting Strike Price
When it comes to selecting your strike prices, the optimal strike is largely subjective and will be dependant on the strategy you are using and your outlook for the stock.
- Buy ITM and Sell OTM — High probability that the trade will be successful as the stock price doesnt have to move for the position to be profitable at expiration. However, the tradeoff is that buying ITM options are more expensive, thereby increasing your loss potential.
- Buy OTM and Sell OTM — Lower probability that the trade will be successful as the stock will need to move in your direction, otherwise it will expire worthless. However, the trade will not be as expensive, thereby reducing your loss potential.
- Sell ATM and Buy OTM — Lower probability that the trade will be successful as there’s little room for the stock price to move against you. However, there is more profit potential.
- Sell OTM and Buy OTM — Higher probability that the trade will be successful as there’s more room for the stock price to move against you before it can turn ITM. However, there is less profit potential.
Regardless of whether the market moves upwards, downwards or sideways, there is a vertical options strategy available to help you take advantage of modest price fluctuations in a risk defined manner.