Our chief market strategist breaks down the day's top business stories and offers insight on how they might impact your trading and investing.
Comfortable with calls and puts? Then maybe it’s time to bring on the spreads.
I’ll admit it. Spreads are more complex than a single put or call purchase. But, they’re nowhere near as difficult to implement as the name might imply.
When you buy or sell a call or put on an underlying instrument such as a stock, you’re typically using only one strike price in a single month. And yes, spreads might involve a variety of strikes, or perhaps multiple months. No sweat. You’re simply building your spread with option components that you’re likely already familiar with (or will be, with a quick brush-up).
An option spread combines two contracts, called legs, to create what’s essentially a single position. Ideally, however, the two legs limit the additional risky exposure that might come with taking just one position.
Over the coming months, we’ll walk you through a few basic option spreads. Here’s step one, the vertical spread.
Before we start looking “up,” let’s look a little deeper into the potential benefits, and turn-offs, of an options spread. Spreads can help reduce the risk from an option, or an underlying, that turns against you. Of course, with that protection, there’s a sacrifice: a spread can limit the maximum upside potential that you might have collected with an outright share position, or with a single call or put position. In other words, you may leave some money on the table, but at least you might return to trade another day.
Using spreads can also cost you less in capital risk tied up in a single option trade. You might instead spend that capital on another investment, possibly with the goal of increasing portfolio diversification.
And now, the vertical itself. It’s an option spread designed to take advantage of a directional move in the underlying security. The spreads are considered “vertical” because the options are on the same underlying security in the same expiration month, but at different strike prices.
With a call-vertical spread, you’d simultaneously buy one call option, and sell another call option, at a different strike price, in the same underlying, in the same expiration month. A put-vertical spread involves simultaneously buying a put option and selling another, at a different strike price in the same underlying, in the same expiration month. If you’re expecting the underlying to move up in value, you would typically sell a put vertical or buy a call vertical, which would be considered a bullish vertical. Conversely, if you’re feeling bearish, you would buy a put vertical or sell a call vertical.
A bullish vertical is always long a lower-strike option and short a higher-strike option (either a long-call vertical or a short-put vertical). Conversely, a bearish vertical is always short a lower-strike option and long a higher-strike option (either a long-put vertical or a short-call vertical). For example, on stock XYZ, you might sell the December 195 call, and buy the December 200 call. This would be referred to as a short Dec 195/200 call vertical. This vertical is also a bearish position, so ideally, you’d want the shares of XYZ to trade lower, below the short 195 “leg” in the vertical. You profit when the price of the underlying shares of XYZ remain below the entire vertical through options expiration.
When you sell your vertical, a credit will be collected. Your goal, in this case, is for the underlying to remain within a narrow trading range, so the credit received upon initiation can be retained.
You’ll need three out of four market situations to help this trade be successful:
Buying a vertical can be more straightforward than selling, because the initiating debit paid for the position plus the transaction costs is the extent of your risk on the trade. With the former, your long option is closer to the price of the underlying, and that price rises if it moves in the direction of your vertical.
Now, the cautionary tale. When buying, you need the underlying to move through your break-even price, to expand the closing value of the trade, in order to consider it a winner. Ideally, the underlying trades completely through both strikes in the vertical. So, prepare yourself for the risks involved should that not happen.
And there you have it. A gentle (I hope) nudge toward spreads, and a little reassurance that thinking vertical doesn’t have to bring on vertigo. While complex in nature at first, verticals provide a cost-effective path to a risk-defined directional position.
Go to tradewise.com and enter coupon code "ticker" at checkout.
Start your free trial
When the two months have passed, keep the TradeWise service for just $20 per strategy per month
for thinkMoney ®
Financial Communications Society 2016
for Ticker Tape
Content Marketing Awards 2016
*Select any two trading
strategies and receive them for two full months—an $80 value. If you want to keep the tips coming, it’s only
$20 per month, per strategy. If you do not cancel, you will be charged $20 per
strategy per month. For more information about TradeWise Advisors, Inc., please
see the Disclosure Brochure (ADV Part
2A). Limit one TradeWise registration per account.
TradeWise Advisors, Inc.
and TD Ameritrade, Inc. are separate but affiliated firms. Advisory services
are provided exclusively by TradeWise Advisors, Inc. and brokerage services are
provided exclusively by TD Ameritrade, Inc. For more information about
TradeWise, please see ADV 2
TradeWise strategies are not intended for use in IRAs, may not be
suitable or appropriate for IRA clients, and should not be relied upon in
making the decision to buy or sell a security, or pursue a particular
investment strategy in an IRA.
The information contained in this article is not intended to be investment advice, and is for illustrative purposes only. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
TD Ameritrade does not make recommendations or determine the suitability of any security, strategy or course of action, for you through your use of trading tools or technical trading indicators. Any investment decision you make in your self-directed account is solely your responsibility.
Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. These are advanced option strategies and often involve greater risk, and more complex risk, than basic options trades.
Maximum potential reward for a credit spread is limited to the net premium received, less transaction costs. The maximum loss is the difference between strikes, less net premium received, plus transaction costs.
Maximum potential reward for a debit spread is limited to the difference between strikes, less net premium paid. The maximum loss is the net premium paid and transaction costs.
Market volatility, volume, and system availability may delay account access and trade executions.
Past performance of a security or strategy does not guarantee future results or success.
Options are not suitable for all investors as the special risks inherent to options trading may expose investors to potentially rapid and substantial losses. Options trading subject to TD Ameritrade review and approval. Please read Characteristics and Risks of Standardized Options before investing in options.
Supporting documentation for any claims, comparisons, statistics, or other technical data will be supplied upon request.
The information is not intended to be investment advice or construed as a recommendation or endorsement of any particular investment or investment strategy, and is for illustrative purposes only. Be sure to understand all risks involved with each strategy, including commission costs, before attempting to place any trade. Clients must consider all relevant risk factors, including their own personal financial situations, before trading.
This is not an offer or solicitation in any jurisdiction where we are not authorized to do business or where such offer or solicitation would be contrary to the local laws and regulations of that jurisdiction, including, but not limited to persons residing in Australia, Canada, Hong Kong, Japan, Saudi Arabia, Singapore, UK, and the countries of the European Union.
TD Ameritrade, Inc., member FINRA/SIPC. TD Ameritrade is a trademark jointly owned by TD Ameritrade IP Company, Inc. and The Toronto-Dominion Bank. © 2019 TD Ameritrade.