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Out-of-the-Money Spreads: Potentially Expand Profit Options

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January 13, 2014

You may be aware that options can be used to create strategies to fit even the most diverse of risk profiles. By combining options with one another, not only can you make use of bullish, bearish, and even neutral markets, but you can also take into account factors such as volatility and time. For this segment, let’s take a look at some out-of-the-money vertical spreads.

Up, Up, And Away: The Long Call Vertical Spread

So you think the market is going to make a move—a big, upward move. You could buy some out-of-the-money call options and wait for the market to launch. But what if the calls you had in mind are far more expensive than you anticipated? Unless the market moves quickly, you could see the value of your investment erode dramatically through the effects of time decay.

An alternative to buying straight calls is to create a long out-of-the-money call spread (see figure 1). To do so, you buy an out-of-the-money call and simultaneously sell a call with a higher or further out-of-the-money strike than that of the call you bought. So, for example, suppose you were interested in creating a bullish trade on stock XYZ, currently trading for $48 per share. To create a long out-of-the-money call spread, you could:

Buy one XYZ January 50 call — and — Sell one XYZ January 55 call.

PROFIT/LOSS CURVE OF A TYPICAL LONG OUT-OF-THE-MONEY CALL VERTICAL SPREAD.

FIGURE 1: PROFIT/LOSS CURVE OF A TYPICAL LONG OUT-OF-THE-MONEY CALL VERTICAL SPREAD. Maximum potential profit is achieved at or above the short option’s strike price, while the maximum potential loss is reached at or below the long option’s strike price. For illustrative purposes only.

Let’s further suppose that the Jan 50 call is trading for $2.50, while the Jan 55 call is trading for $1. Then, the value of the 50/55 call spread would be the difference between those two prices, or $1.50.

The most that you can make on a long vertical spread is the difference between the strikes less the amount that you paid for the spread. Since the difference between your two strikes is $5, it follows that your maximum potential reward on this trade is $5 – $1.50, or $3.50 (less transaction costs).

An added benefit of this trade is that it has a lower breakeven level compared to either of the call options alone. This means that the market may not have to move as much in order for you to start to make a profit.

The breakeven level on your long call spread is the lower strike (50) plus the price that you paid for the spread ($1.50), or $51.50. Compare that to the breakeven level of the Jan 50 call ($52.50) or to that of the Jan 55 call ($56), and you can see where the spread holds the advantage.

Up, Sideways, And... Down? The Short Put Vertical Spread

Let’s make this even more interesting … how about a strategy such that if the market goes up you make money, if the market goes sideways you make money, and if the market goes down a little, you still have some chance of making money? Sound too good to be true? That’s what a short out-of-the-money put spread can offer.

To sell an out-of-the-money put spread, you sell an out-of-the-money put and simultaneously buy a put with a lower or further out-of-the-money strike (figure 2). For example, with stock XYZ trading for $48 per share, to create a short out-of-the-money put spread, you could:

Sell one XYZ January 45 put — and — Buy one XYZ January 40 put.

PROFIT/LOSS CURVE OF A TYPICAL SHORT OUT-OF-THE-MONEY PUT VERTICAL.

FIGURE 2: PROFIT/LOSS CURVE OF A TYPICAL SHORT OUT-OF-THE-MONEY PUT VERTICAL. Maximum potential profit is achieved at or above the short option’s strike price, while the maximum potential loss is reached at or below the long option’s strike price. For illustrative purposes only.

Let’s further suppose that the Jan 45 put is trading for $2, while the Jan 40 put is trading for $1. Then, the value of the 45/40 put spread would be the difference between those two prices, or $1.

Remember, however, that you are selling the spread. Therefore, the most you can make is $1, which is the amount at which you sold the spread.

The bad news is that since the difference between your two strikes is $5, your maximum potential loss on this trade is $5 – $1, or $4.

So why would you place this trade if the reward-to-risk ratio is so unfavorable? Well, think about the following three scenarios:

  • If XYZ rises and settles above its current price of $48 per share, you get to keep your dollar.

  • If XYZ does nothing and settles right at $48 per share, you get to keep your dollar.

  • Finally, if XYZ drops in value, so long as it does not drop below $45 per share, you get to keep your dollar.

In fact, in order for you to lose money on this trade, XYZ actually has to drop below your breakeven level of $44 per share.

Last Words

Be aware that you can place these trades as spreads, and that while there is one price for each of the options, you only have to worry about one price for the spread. TD Ameritrade will fill in the individual option prices of each leg of the trade, and typically charges just one commission for the trade, plus a contract fee for each contract traded. Further, TD Ameritrade routes the orders for vertical spreads as such, so the exchanges know to execute them as spreads. So you won’t have to worry about getting filled on one leg of the spread and not the other.

As you can see, these vertical spreads can be useful for options traders of all risk appetites. The long out-of-the-money call vertical allows you to be bullish for a lower cost than just buying the long call alone. The short out-of-the-money put spread allows you to potentially profit even if you’re wrong on the direction you thought the stock was headed.