Editor's Note: As of October 3, 2016, RED Option is now TradeWise.
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:
If the underlying is moving sideways for a period of time;
If the underlying is moving up and down within a small range, and not going in one particular direction for an extended period of time;
If the underlying has a relatively large move, but does not go over the short vertical strike price on the upside or downside.
And the fourth situation—selling a call or put vertical—will disappoint, if the market has a relatively straight-line move in one direction, crossing over the short strike price, without pulling back. Remember, verticals are directional trades, but they’re risk-defined in nature. This means your maximum potential gain is the difference between the two strike prices less the cost of the allocation. The maximum potential risk is the outlay for the position. This is the most important part of the vertical, and a great launch into increasingly complex option trades.
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.
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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.
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