One of the primary advantages of option trading is the chance to define and potentially limit risk right up front. That is, option traders target a trade that they believe puts them in a high-probability situation to make some money or limit potential downside. One way to do that is with short vertical spreads. (I posted a look at Apple (AAPL) and a long call vertical spread earlier this year.)
There’s a tasty little sample stock that can help us explore short verticals: Starbucks (SBUX). Let’s say that due to chart configurations or price action or just because you’re buzzed up on cappuccinos you decide that SBUX is a bit overdone and you’d like to sell it short. You could go out and short the stock, but doing so ties up a lot of capital (the risk of loss on a short sale is potentially unlimited since there is no limit to the potential price increase of a security) and defining your risk is a bit more negligible.
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Instead, you might turn to the options market. Have a look at the options chain in figure 1, which shows the May Weeklys option chain (expiration May 1, 2015). Just as an example, I’m going to point to Starbucks (SBUX) and specifically, where it stood near the close of trading on March 24, 2015. This isn’t a comment on the stock but the prices available that day in this particular stock help illustrate the thinking behind a short vertical spread strategy.
Let’s sketch out our trade a couple of different ways. If you expect the underlying stock price to go down, you might consider buying an at the money put. A chain check reveals the May 97.5 put is trading for a theoretical value of $2.54. You next look at the thinkorswim® platform’s Prob ITM column and would see the probability that the put is going to expire in the money is 49.58%, or rounding up is about a 50/50 shot of being in the money on expiration day. However, you are paying more than $2.50 for the privilege of those so-so odds. Let’s dig a little deeper. For the sake of math simplicity, let’s start your “tab” with $2.50. Your potential breakeven on expiration day for that put is $95 (97.50-2.50). As we look on our option chain we see that the probability that the 95 put will be in the money on expiration day is 35.62%, so in essence we are paying $2.54 in theoretical value and now with just about a 35% probability that we will break even on expiration day. For me, that bill is too steep for those odds.
Let’s look at it another way without changing our view of the stock. What if we were to sell a call? For our example, let’s target the May 100 call for a number of reasons. Out of the gate, you’ve already established your belief SBUX is not going above 100. At the moment of this chart screen grab, there’s a 36.41% probability SBUX underlying will be above 100 on expiration day. But what we really care about is that there’s a 63.59% probability that it will be below 100. Are there some drawbacks to our perhaps oversimplified hunch? Yep. The first one is that holding this naked short call position will take significant capital because theoretically the stock can go up forever. But for me the major hang up here is undefined risk. To potentially limit that risk we might evolve our thinking. If we sell an out of the money call, and let’s make our move on our already familiar May 100. Next let’s define the risk by also purchasing the May 102 call. We are short the May 100 and long the May 102 call and if we put this spread in to fill at what our chart sample tells us is a theoretical price that would be $0.65 ($65 when using the options multiplier, representing 100 underlying shares). Keep in mind that spread option strategies can entail substantial transaction costs, including multiple commissions, which will impact any potential returns.
Let’s cover a few more details. If the stock holds or rallies slowly but stays under $100 over the next 38 calendar days, we keep the $65. The challenge comes if the stock price goes over $100 as we sold the spread for $0.65, our breakeven is $100.65. The good news is that this spread by definition can only be worth $2. Therefore even if we go to $500 the spread is worth $2. This is my favorite part about this trade: stock goes down, we make money; if we go sideways, we make money; we can even go up a tad (just over 2%) and make money. Now, do stocks always behave the way we like? Nope. But because we defined our risk with this spread, we know the most we can lose is $1.35 or $135.
All About Probability
The next logical question is why would I risk $135 to make $65? The reason is all about probability. Let’s dig in to the details. One of the things to understand is that options are nothing more than probabilities. Nothing is a sure thing, but applying options trading to stock trading can again help us define risk, give us an idea of what we’re up against. If we have a spread that can go to $2, let’s call that our total risk, and we collect $0.65 on the transaction then our “real risk” has just been shaved to $1.35 (2.00- 0.65). Now if we take our real risk of 1.35 and divide by our total risk of 2.00 we get a percentage of probability that we can get our heads around. In this case, 67.50%.
Probabilities are what they are the second you make the trade, they may and most likely will move over time. In our sample, the two calls were both out of the money, that is they have zero intrinsic value, only time premium. Therefore the option we sold will have to decay at a faster rate than the option we purchased. In this case, time decay is on our side. As the stock moves up, the probabilities will go against us because there’s a stronger chance of the 100 strike call being in the money.
When Time is On Your Side
A bit more on time decay. Notice that on the sample trade we picked, the May timeframe is 38 calendar days away. Because time decay is the basis of a short vertical, I like to use a 4-10 week timeframe when selling verticals. I’ll make a point about our sample SBUX, again not a recommendation. But this particular stock is a name that most know that has a stock and options market with good liquidity, which can mean tighter prices. I like to trade where everyone else is trading. The tighter the market, the less I have to give up to get in and out of trades and the improved probability of getting filled at the theoretical price. Our probability of success on this trade was 67.5%. That’s in my comfort zone as I like to use trades that have a 50-75% probability of making money. Using this range gives me a chance to be paid a reasonable amount of money for the risk I am taking. However, I want to make sure I receive enough up front to make the trade worthwhile after costs.
I Don’t Tinker
Now, once I am in this trade I am not a big fan of making adjustments. I’ve already crunched the numbers: what I believe I can make, what I know I might lose. Now, should the trade move against you, you can potentially limit your exposure if you’re not all in at the start. You might instead sell some of the contracts you’ve targeted at first and that way if it goes against you, you can use the movement to sell the same spread at a better price, or adjust the strikes and sell strikes that are a bit higher.
Now that we are in our short vertical spread, let’s talk about how we get out of it. I like to close spreads like this with 4-10 days to expiration. Some traders will argue that time decay is greatest in the last four days of expiration. If talking about straight percentage, I agree. But in real money terms that is not necessarily true. Some TD Ameritrade clients share that they like to close out when they capture 80% of the total return. The important thing is to establish a set of rules that you can live with and have the discipline to stick with.
Of course our example centered on a bearish viewpoint. Bulls would consider selling a put spread.
Yes, short vertical spreads involve a few moving parts. They are advanced strategies and involve greater risk, and more complex risk, than basic options trades. But for options traders looking to expand their tool box, this approach allows for a directional bet in a risk-defined scenario in a set timeframe and with known amount of capital invested.
For the sake of simplicity, the examples above do not take transaction costs (commissions and other fees) into account. Transaction costs for trades placed online are $9.99 for stock orders, $9.99 for option orders plus a $0.75 fee per contract. Option exercises and assignments incur a $19.99 fee.