One of the basic directional spreads when learning to trade options is that of the vertical spread. It is extremely versatile and represents a major building block of more complex spreads. It is so named because of the configuration of the position when overlain on the classic format for displaying option quotes. In this format, the various strike prices for an option are arrayed vertically and the months available to trade are displayed horizontally. This defined risk position consists of both a long and short position at different strike prices within the same expiration month. It can be constructed in either puts or calls and the initial cash flow can be either a credit or debit. Strike prices can be selected to produce either aggressive or conservative stances.
As an example, let us consider a vertical spread in market leader Apple (AAPL). Current vital signs of the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.
For the trader who has a bullish thesis for the price action in AAPL into December expiration, a put credit spread can be established by selling the December 540 put and buying the December 530 put. As this is written with 31 days to expiration, the maximum potential return is 30% and is achieved as long as AAPL remains above the short put strike of 540. Maximum risk is defined by the long 530 put.
As contrasted to a naked put sale, this position has the following major differences: 1. Risk is crisply defined as opposed to the naked sale maximum risk of the underlying going to 0, and 2. Margin requirements for the position and hence yield are dramatically improved.
Senior Options Instructor