When trading vertical options spreads, the maximum risk and profit potential are defined and relatively straightforward to calculate. Here’s how to assess the risk parameters on vertical spreads.
Option traders will often trade a consistent quantity when initiating vertical spread trades. Although this method keeps the contract numbers orderly, it ignores the fact that each vertical spread has a different risk profile based on a few considerations:
With this information, you can determine the amount of risk and potential reward per contract.
After that we’ll take it one step further and show you how to choose your trade size by looking at a trade’s risk parameters in the context of your overall portfolio risk.
When placing a debit spread, the risk amount is the price of the spread plus any transaction costs. The potential reward equals the spread width minus the debit price, minus 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), which equals $1.40 or $140 per contract (minus 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 minus 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’d subtract the credit received ($0.52) from the width of the vertical ($2.00), which equals $1.48 or $148 per contract (plus transaction costs). Your potential reward would be your credit of $0.52 or $52 per contract (minus transaction costs).
Need a visual description of vertical spread risk parameters? Scroll the gallery in figure 1 below to see each of the four types of vertical spreads: long call, short call, long put, and short put.
FIGURE 1: LONG CALL VERTICAL. For illustrative purposes only.
FIGURE 1: SHORT CALL VERTICAL. For illustrative purposes only.
FIGURE 1: LONG PUT VERTICAL. For illustrative purposes only.
FIGURE 1: SHORT PUT VERTICAL. For illustrative purposes only.
Now let’s take it a step further. Once you know your risk per contract on a vertical spread, you need to determine how much you’re willing to risk on the trade.
After you’ve set that dollar amount, you can calculate the maximum number of contracts you’re able to 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 $1,000 as the maximum amount you’re willing to risk on a trade. Let’s take a look at the debit vertical spread above—the XYZ 40-42 call spread which was purchased for $0.60 ($60 with the multiplier).
Because $60 represents your maximum risk per contract, you could buy 16.66 contracts ($1,000/$60). And because 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 would lose $960 ($60 x 16), which is less than our $1,000 risk amount. This debit spread’s potential profit would be $2,240 ($140 x 16), if XYZ is above $42 at expiration. And don’t forget those transaction costs.
Credit Spread Example
For the credit spread, determining the number of contracts to sell would be calculated by dividing $1,000 by the $148 per contract risk amount, which equals 6.76 contracts, rounded down to six contracts. If the spread went to its full value of $2.00—if XYZ stock falls below $34 at expiration—the loss would be $888 ($148 x 6 contracts). The potential reward would be $52 x 6 contracts or $312 (minus 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 $1,000, 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.
Doug Ashburn is not a representative of TD Ameritrade, Inc. The material, views, and opinions expressed in this article are solely those of the author and may not be reflective of those held by TD Ameritrade, Inc.
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