Vertical spreads are a common choice for options traders looking for a flexible defined-risk strategy. But how do you choose among strategies? Here's a handy checklist to follow.
Some choices are easy, like the way you put your jeans on. Not only are you most likely to go with the fly-in-the-front, one-leg-at-a-time method, but it’s also the obvious choice. If you trade options, not only do you need to know whether you think a stock will go up or down, but you have to consider volatility (vol), too. Is it high or low? Will it go up or down from here? This is where traders get hung up on strategy. Once you have the information you need, which options spread do you run with? Is there a way to automate the decision-making process? Perhaps.
Vertical spreads in particular are guilty of befuddling even the best of ’em. You may recall a vertical spread is a defined-risk strategy that lets you make bullish or bearish speculative trades. And they’re flexible. You can create a vertical with minimal risk or a lot of risk. A vertical could be a short-term speculation or long-term directional play.
Vertical spreads are straightforward. They’re composed of either a long and short call or a long and short put in the same expiration. Remember, if we’re talking about bullish verticals, the two choices are long call verticals for debit or short put verticals for a credit. If we’re talking about bearish verticals, your choices are long put verticals for a debit or short call verticals for a credit. Which one is which? Use the cheat sheet.
Now consider the $64,000 question: Which one should you choose? Debit spread or credit spread? At the money or out of the money (OTM)? What about expiration? When you’re faced with an array of call and put options, with perhaps dozens of strike prices and expirations, choosing a vertical can feel like a daunting task.
Well, fear not. What you should consider is a quick checklist of easy metrics that helps you choose with confidence. As with all things trading, there are no guarantees. This checklist is a way to get started, not necessarily the end point. As an option trader, you still need to determine whether a particular vertical is a good choice. But a good checklist can make the decision-making process move faster so you can take advantage of new potential opportunities.
When trading options, start with vol—more specifically, whether the vol of a stock or index option is relatively high or low. Now, let’s be clear. No matter how high vol might be, it can always go higher. And no matter how low it might be (unless it’s zero), it can always go lower. So for starters, put the present vol in context through the “IV percentile.” This is a metric that compares the present overall implied volatility (IV) of an underlying’s options to its past highs and lows.
Where to find it. The IV percentile measures where the overall IV of a stock or index is relative to its high and low values over the past 52 weeks. Find it in Today’s Options Statistics on the Trade tab of the thinkorswim® platform from TD Ameritrade (see figure 1).
FIGURE 1: KNOW THE CURRENT IV PERCENTILE. Find the IV percentile of an option by selecting Today’s Options Statistics from the Trade tab on thinkorswim. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only.
The stock in this example shows an IV percentile at 22%. In the Today’s Options Statistics section, you’ll find the data that’s used for the IV percentile calculation. Besides the IV number, which is the overall IV for the symbol you’re looking at, there’s the “52 week IV High” and “52 week IV Low.” If the 52-week IV high is 50%, the 52-week IV low is 19%, and the IV is 25.8%, then the IV percentile is 22%.
How to calculate. The IV percentile formula takes the present IV, subtracts the 52-week low IV, and then divides that by the 52-week IV high minus the 52-week IV low. That is (25.8% – 19%)/(50% – 19%) = 22%. Pretty simple, but you’ll save time because it’s calculated for you.
The higher the IV percentile, the closer it is to its 52-week high. The lower the IV percentile, the closer it is to its 52-week low. A 50% IV percentile means the current IV is in the middle of its 52-week high and low IV values—and that’s a benchmark to consider when using debit or credit strategies.
You can also take a look at the Imp Volatility study on the Charts tab. This study displays the historical values of the overall IV number used in the IV percentile formula. You can also estimate when the 52-week high and low IV values occurred. Sometimes a short-term spike, or collapse in the underlying’s IV, can skew the IV percentile. This might help you spot where that happened and give you greater context around that IV percentile number.
How can IV percentile help? When IV is higher, it makes credit spreads more expensive. For example, with a stock at $50, the short 47/48 put spread might have a theoretical value of 0.25 when IV is 15% but 0.35 when the IV is 25%. Shorting the 47/48 put spread for a 0.25 credit would give you a max potential profit of $25 if the stock is above $48 at expiration, and a max potential loss of $75 if the stock is below $47 at expiration. Shorting the 47/48 put spread for 0.35 credit would give you a max potential profit of $35 and a max potential loss of $65.
Selling that put spread for a 0.35 credit gives you a larger potential profit, and smaller potential loss, than selling it for a 0.25 credit. A higher IV percentile, say, when it’s over 50%, can suggest a situation where a stock’s short verticals might give you larger credits.
Likewise, when IV is lower, it can make credit spreads less expensive and deliver smaller potential profits and larger potential losses compared to verticals at the same strike price when IV is higher. When the IV percentile is lower than 50%, that’s when you might consider debit spreads instead.
So, when the IV percentile is, say, above 50%, you might select trades by looking at credit spreads—short put spreads if you’re bullish; short call spreads if you’re bearish. When the IV percentile is under 50%, you might select trades by looking at debit spreads—long call spreads if you’re bullish; long put spreads if you’re bearish.
After looking at the IV percentile when it’s above 50%, you may want to select verticals by picking an expiration that matches the time frame for your directional trade. Let’s say you want to speculate that a stock might rise in the next 60 days. In this case, find an expiration close to 60 days, then open up the option chain.
How do you find an option to consider selling that’s part of that short put vertical?
To trade vertical spreads on the thinkorswim platform from TD Ameritrade, go to the Trade tab and pull up an Option Chain (figure 2).
FIGURE 2: WHICH STRIKES ARE YOU GOING TO TRADE? Once you’ve selected the strikes, you can think about placing a vertical spread. Chart source: the thinkorswim® platform from TD Ameritrade. For illustrative purposes only.
As an option trader, it’s up to you to determine a suitable credit for a short put vertical. If you aren’t finding short put spreads that give you a one-third credit, this is a clue you may want to consider debit spreads—in this case, a bullish long call vertical. Start by looking for the long call that’s the first in-the-money (ITM) strike. Choose it, select Buy, then Vertical. Look at the debit for the long call vertical that’s created in the Order Entry section. If necessary, change the short call strike to the first OTM strike. One thing to look for is to see if the debit is less than the intrinsic value of the long call. If the stock price is $50, and the debit of the long 49/51 call vertical is 0.90, then it’s 0.10 less than the $1 intrinsic value of the long 49 call. Intrinsic value exists only for ITM options. It’s the stock price minus the strike price for ITM calls, and the strike price minus the stock price for ITM puts.
When the debit is less than the intrinsic value, it’s possible the debit of the vertical will “grow” into that intrinsic value at expiration if the stock price stays where it is. The profit would be the difference between the intrinsic value and the debit of the long vertical. Again, you decide on the appropriate debit to pay for a long vertical. The debit versus intrinsic value can be one benchmark you evaluate.
This IV-percentile-driven method of finding credit or debit verticals as speculative tools teaches you to quantify them. There’s no guarantee that finding verticals this way will yield profitable trades. But at the least, it’s a way for you to make comparisons between debit and credit spreads, between two or more debit spreads, or between two or more credit spreads. You can also compare verticals among different underlyings and learn to quantify their relative opportunities.
So go ahead and tweak the targets for IV percentile, probability, debits, credits, and strikes. But make it a structured, informed process that you can repeat quickly and efficiently.
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