Many options traders say that they trade a consistent quantity when initiating vertical spread trades. And while this strategy might keep the contract numbers orderly, it ignores the fact that each vertical spread has a different risk amount based on a few things:
- Is it a debit spread or a credit spread?
- How wide is the spread (the difference between the strikes)?
- How much did you pay (for a debit spread) or collect (for a credit spread)?
With this information, you can determine the amount of risk and potential reward per contract.
When placing a debit spread, the risk amount is the debit price plus any transaction costs. The potential reward equals the spread width minus the debit price, less transaction costs. For example, let’s look at a spread in XYZ consisting of the purchase of the 40-strike call and the sale of the 42-strike call of the same expiration date (the “XYZ 40-42 call vertical” in trader parlance). Let’s assume a trade price of $0.60.
In this case, the risk amount would be $60 per contract. The potential reward would be the difference between the strikes ($2.00) minus the debit amount ($0.60) = $1.40 or $140 per contract (less transaction costs).
To determine the risk amount of a credit spread, take the width of the spread and subtract the credit amount. The potential reward on a credit spread is the amount of the credit received less transaction costs. To illustrate, let’s say you sold the XYZ 36-strike put and bought the XYZ 34-strike put (the “XYZ 36-34 put vertical”) for a $0.52 credit. To calculate the risk per contract, you would subtract the credit received ($0.52) from the width of the vertical ($2.00) = $1.48 or $148 per contract (plus transaction costs). Your potential reward would be your credit of $0.52 or $52 per contract (less transaction costs).
Using Dollars Risked to Determine Trade Size
OK; let’s take it a step further. Once you know what your risk per contract on a vertical spread, you need to determine how much you’re willing to risk on the trade.
Once you’ve set that dollar amount, you can calculate the maximum number of contracts you can trade and still stay within your risk parameters. It’s a simple calculation of dividing the number of dollars you’re comfortable risking by the total risk of the vertical.
Debit Spread Example
Suppose you’ve set $1000 as the maximum amount you’re willing to risk on a trade. In the debit vertical spread above—the XYZ 40-42 call spread purchased for $0.60 ($60 with the multiplier).
Since $60 represents your maximum risk, you could buy ($1000/$60) = 16.66 contracts. And since you can’t trade partial contracts, and you don’t want to exceed your maximum risk, you can round down to 16 contracts.
At expiration, if XYZ stock stays below $40, the spread would expire worthless, and the spread would lose ($60 x 16) = $960, which is less than our $1000 risk amount. This debit spread’s potential profit would be ($140 x 16) = $2240, if XYZ is above $42 at expiration. And don’t forget those transaction costs.
Credit Spread Example
For the credit spread, to determine the number of contracts to sell, you would divide $1000 by the $148 per contract risk amount, which equals 6.76 contracts, rounded down to 6 contracts. If the spread went to its full value of $2.00—if XYZ stock falls below $34 at expiration— the loss would be $148 x 6 contracts or $888. The potential reward would be $52 x 6 contracts or $312 (less transaction costs).
Knowing your maximum risk and potential profit is one of the foundations of sound trading. Running through these simple calculations before you initiate a trade can help you keep your strategy in perspective.
As a final note, for this exercise we assumed a maximum trade risk of $1000, but really, this number should be determined by asking yourself how much of your total trading capital you’re willing to risk on any one trade. Many veteran option traders would tell you to keep that number relatively low. Some trades will go your way and some will go against you, but no one trade should take you out of the game entirely.
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