One of the basic directional spreads when learning to trade 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.
As an example, let us consider a vertical spread in Apple (AAPL). The stock has dropped considerably over the last several weeks just like the prospect of Aaron Hernandez’s NFL career, and at the time of this writing is hovering around $400. With AAPL being heavily traded, the option chain show tremendous liquidity, a tight bid ask spread, and moderately elevated implied volatility.
For the trader who has a bullish diagnosis for the price action in AAPL into July expiration, a put credit spread can be established by selling the July 380 put ($4 credit) where it has a pivot low and buying the July 375 put ($3 debit). The total premium received is $1. At the time of this writing there are 23 days to expiration, the maximum potential return is 20% and is achieved as long as AAPL remains above the short put strike of 380. Maximum risk is defined by the long 375 put. The maximum risk is defined by taking the difference in the strikes $5 (380 – 375) minus the premium received ($1) or $4 if AAPL finished below $375 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.
Senior Options Instructor