One of the basic directional spreads when trading options is that of the vertical spread. It can be extremely versatile and represents a major building block of more complex spreads. With a vertical spread, the various strike prices for an option are arranged vertically and the expirations 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. It can be constructed with 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 depending on the outlook and the risk/reward that is desired.
In conjunction with this blog, Dan’s Online Education series this month is all about “Mastering Vertical Spreads”. The series will cover essentially everything you need to know about them including analyzing, managing and adjusting the spreads. Please take a look at the Options Education section of our website for more information and the additional education that is included.
As an example, let us consider a vertical spread in Apple (AAPL). The stock has dropped considerably over the last several weeks to the chagrin of many investors and at the time of this writing is hovering around $101. With AAPL being heavily traded, the option chain show tremendous liquidity, a tight bid ask spread, and elevated implied volatility.
For the trader who has a bullish diagnosis for the price action in AAPL just ahead of earnings later this month, a put credit spread can be established by selling the January 100 put ($1.50 credit) where it has a pivot low and buying the January 95 put ($0.50 debit). The total premium received is $1. At the time of this writing there are 10 days to expiration, the maximum potential return is 20% and is achieved as long as AAPL remains at or above the short put strike of 100. Maximum risk is defined by the long 95 put. The maximum risk is defined by taking the difference in the strikes $5 (100 – 95) minus the premium received ($1) or $4 if AAPL finished at or below $95 at expiration.
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 zero, and 2. Margin requirements for the position and hence yield are dramatically improved. Understanding the potential risk of each strategy and implementing the one that matches your trading personality can go a long way at making you feel comfortable and successful as a trader. And remember to check out Dan’s class!
Senior Options Instructor