People often ask me what separates successful option traders from the rest, and they think the answer is going to be some complex set of rules, or analysis, or secret handshakes. But in my opinion, a pro's positions can still be profitable even if they're wrong on the direction of the stock or index. That might not sound too special. But for me and the traders I know, choosing the right strategy trumps trend-picking skills. And choosing the right strategy requires a playbook that goes well beyond long single calls or puts.
Sure, a complete playbook might contain everything from butterflies to calendars. But there's one spread—the vertical— that underlies the bulk of all the more complex strategies combined. And, it can be profitable, even if your directional pick isn't right, and it can help insulate you from changes in time and volatility. In fact, the vertical could be the most important option strategy you ever learn.
The Mighty Vertical
Here's the problem with only buying single calls and puts. In order to be profitable, three things need to happen:
- The stock needs to move in the right direction
- The move has to be big enough
- It has to happen before expiration
By choosing the appropriate vertical:
- The stock can move in the opposite way you think it will, or not at all
- The stock can move a small amount
- Time passing can be beneficial
If you want to pick a horse at the track, trade long options. If you want a more reliable strategy, even if a little dull, consider trading verticals. Many consider them to be building blocks of options trading, not individual calls and puts. And while describing a vertical can be pretty straightforward, where to put the vertical can be a little more difficult to decide. So, let's start with easy definitions.
A vertical spread is composed of two options—one long and one short—which are either both calls or puts. Both options are in the same expiration and the same quantity.
Inside a vertical, when the stock moves one way or the other, all things being equal, one option is making money, and the other option is losing money. They offset each other. Not equally, but enough so that verticals can be one of the tamest positions in your options playbook. The reason? If the long and short strikes of the vertical are relatively close, say, at adjacent strikes, the greeks of the options can be pretty close to each other. (See sidebar, right.)
Take a look at the greeks of the options on the Trade page of the thinkorswim® trading platform, They're fairly equal at adjacent strikes, and less equal at further strikes. With one option long and the other short, the gamma and vega, especially of verticals, is usually much lower than an individual option at the same strikes. Even vertical deltas are lower, too. But widen out the strikes, and the greeks of the vertical start to get much bigger.
Now, you can buy verticals, or sell them short. Consider the four basic versions in Figure 1.
At expiration, a vertical will always have a value between $0 (when both options of the vertical are out of the money), and the difference between the long-and-short strikes (when both options are in the money). For example, if you're long an XYZ 49/52 bullish call vertical, it would be worth $0 if XYZ is below $49, or $3.00 if XYZ is above $52 at expiration. That defines the minimum and maximum values for the vertical, whether long or short. When one option of the vertical is in the money, and the other is out of the money at expiration, the vertical is worth the intrinsic value of the in-the-money option. The XYZ 49/52 call vertical wouldbe worth $1.00, if XYZ is $50 at expiration, or $2.50 if XYZ is at $51.50 at expiration (not including transaction costs).
Location is Everything
The kind of vertical you use—long or short—and its strikes, determines how it might profit. If you want a long vertical to be at its maximum value at expiration, you place the strikes at levels you think the stock will move beyond—either higher for a long-call vertical, or lower for a long-put vertical. If you want a short vertical to be at its minimum value at expiration, place the strikes at levels you don't think the stock will reach. Looking at Figure 1, consider a bullish long-call vertical, and a bullish short vertical, both on stock XYZ at $50. Let's say you could buy the 55/56 call vertical for .30 debit, or sell the 44/45 put vertical for .30 credit. The long 55/56 call vertical has a maximum loss of $30, if XYZ is below $55, and a maximum profit of $70, if XYZ is above $56, with a breakeven point at $55.30. The short 44/45 put vertical has a maximum loss of $70, if XYZ is below $44, and a maximum profit of $30, if XYZ is above $45, with a breakeven point at $44.70. Keep in mind that none of these examples include transaction costs which will affect potential profits, losses and breakeven points.
Think about it. Like a long call, you have to be right on three things, for a long-call vertical to profit: XYZ has to rally, it has to rally high enough, and it has to rally before expiration. But, for the short-put vertical to be profitable, XYZ can go up, stay the same, and even drop five points. And, as long as XYZ is above $45 at expiration, the short-put vertical can make money. The out-of-the-money bullish short-put vertical could make money even if the price of XYZ drops a bit.
By example, this is a strategy that could make money even if you're wrong about the direction of the stock. The short-put vertical could make less money than the long out-of-the-money call vertical, but it could make money more consistently. The same is true for short-call verticals, or at-the-money, long call-or-put verticals, where the stock doesn't have to move up or down as much to make them profitable.
The defined risk characteristic of verticals means they can often have less risk than a stock's bullish or bearish position. In high-priced, volatile stocks, verticals can even have less risk than buying individual options, in exchange for limited profit potentials. For example, with XYZ at $50, and the $49 call priced at $1.75, and the $51 call priced at $.80, a bullish position would be buying 100 shares of XYZ, with a maximum risk of $5,000, or buying a 49 call, with a maximum risk of $175, or buying a 51 call with a maximum risk of $80. The bullish long 49/51 call vertical would cost $.95 debit. Its $95 maximum risk is much lower than the long 100 shares, lower than the long 49 call, and only slightly higher than the long 51 call. Again, not including transaction costs.
The downside to verticals? They generate commissions, contract fees and possible exercise and assignment fees for two options, they have limited profit potential, and, like all options, they expire, which can make it difficult to maintain exposure in a particular stock or index, as you'll need to open and close new positions in your portfolio regularly.
But, if you decide verticals might play a role in your trading strategy, how do you decide on a long-call vertical, or short-put vertical, or long-put vertical, or short-call vertical? And how do you pick the strikes? It's not a question of which is “best,” but of which one fits your bullish or bearish outlook for the stock, and if volatility is relatively high or low. Here's an elementary verticals playbook for your consideration.
This playbook is oversimplified, but generally, short out-of-the-money, call-and-put verticals are used when volatility is high, and the trader is less confident in her directional bias. The out-of-the-money vertical gives her more “room” for the stock to move against her, and still be potentially profitable. Long at-the-money verticals are used when volatility is lower, and the trader is more confident in her directional bias. The at-the-money vertical responds more directly to a change in the stock price, because its delta is higher than that of an out-of-the-money vertical.
Of course, if the trader's directional bias is wrong, the at-the-money vertical will lose money more quickly if the stock moves against it. Once you choose a long or short, call-or-put vertical, you can then select the long and short strikes to match how much you think the stock might move, how much risk you're willing to take, how much sensitivity to the greeks you're comfortable with, and how much capital is required.
The next step in your spread-trading evolution is understanding how verticals are the foundation for more complex spreads, such as combining a long-call vertical, and a short-call vertical, to get a butterfly or a condor. (See “Banking on Boring,” page 18, for more on these strategies.) Or perhaps you want to combine a short-call vertical, and a short-put vertical, to get an iron condor. Then, you can roll a short covered call up to a higher strike if you buy a vertical, or you can roll it down to a lower strike if you sell a vertical.
Right now, we're just scratching the surface, and future articles will describe this process in greater detail. But rest assured, if you understand verticals, you'll come to understand how complex strategies make and lose money, and how traders often use them to advantage.