It is normal to see people enrolling for options/stocks trading expecting to be overnight millionaires. However, in reality, there are a lot of strategies and tools that you need to acquire and perfect in order to make it as a trader.
In this article, we shall discuss one example of these strategies, i.e., the vertical spread. We’ll break it down for you so you can decide if it’s something you want to add to your trading arsenal. Read on.
- What is a Vertical Spread?
- How Vertical Spreads Work
- Types of Vertical Spreads
- What is the difference between credit and debit spreads?
- Closing and managing vertical spreads
What is a Vertical Spread?
This is an options trading strategy that involves buying (opening a long position) and selling (opening a short position) options of the same type and expiration but at different strike prices. Keep in mind that the options you are trading have to be of the same type, i.e., put or call options.
The name vertical stems from the positioning of the strike prices, i.e., one being lower and the other higher but within the same expiration cycle.
How Vertical Spreads Work
With this strategy, you trade directionally by stating your trade's maximum profit at entry, as well as the defined risk (the highest possible loss). Since one position will be offsetting the other, this action is what will define whether it will be a debit or a credit spread.
The only thing you need to keep in mind is that with a debit spread, the max loss is known the minute you execute the trade. Therefore, you don’t have much in the way of defensive tactics that you can use to hedge against losing positions.
On the contrary, in a credit spread, the max loss isn’t known making it crucial to actively manage this kind of vertical spread in certain circumstances.
Types of Vertical Spreads
Since we have already mentioned credit and debit spreads earlier in our discussion, it is important that we dive deeper into the different types of vertical spreads.
Here is a detailed breakdown of each strategy:
1. Call Credit Spread
A call credit spread is a strategy that involves selling a call option and buying a call option as protection. Note that these contracts have different strike prices but have the same expiration date.
You should use this strategy if you believe the stock's price is likely to decrease or is trading sideways.
The main advantage of using this position is that it gives credit for the premium received for selling the put option. When you buy the extra call option, it provides protection, thereby minimizing the trade's risk.
However, this trade can also lose money. This happens when the underlying stock moves up too quickly past your strike price.
If you want to know the maximum risk associated with this strategy, get the difference between the strike prices and multiply it by 100.
In addition to that, you can also get the maximum reward for using this strategy. This will subtract the premium paid for protection from the premium received for selling the call option.
2. Call Debit Spread
Next up is a position that involves buying and selling a call option simultaneously at different strike prices and with the same expiration date. It would be wise to use this strategy if you believe that the underlying stock will likely record an increase in price by the time the expiration date hits.
The main benefit of using this strategy is that it can reduce the overall cost of the trade. In fact, it could reduce the trade's breakeven price.
On the downside, this position can lose money when the underlying stock moves downward or sideways. And to know the maximum risk associated with the strategy, it is simply the cost of the premium paid to take on the trade.
Further, the maximum reward is subtracting the premium paid to take on the trade from the difference between the strike price of the two call options multiplied by 100.
3. Put Credit Spread
Another type of credit spread is the put spread, whereby you sell a put option before buying another put option as protection. The two option contracts may have the same expiration date, but the difference comes in the strike prices.
It would be best to use this position when you believe that the underlying stock is either going to trade sideways or record a price increase.
An advantage of using this strategy is that it will limit the overall risk of the trade, and we shall explain how. When you trade this position, it will produce a credit in the form of the premium received for selling the put.
So, when you purchase another put option, it will provide protection, thereby limiting the risk associated with the trade.
But if the stock experiences a sharp downward movement, the trade will likely turn into a losing one.
If you are interested in getting the maximum risk associated with this strategy, get the difference between the strike prices and then multiply it by 100.
4. Put Debit Spread
Last but not least, we have the put debit spread, which is a position that involves buying a put option and selling a put option for the same underlying stock and expiration date but at different strike prices.
The strategy is best used when you believe that the underlying stock's price is likely to decrease. Its benefits include lowering the overall cost of taking on the trade and the breakeven price.
However, if the stock moves sideways or downward, the trade will likely lose money.
Let’s not leave out the maximum risk for this strategy, which is the cost of the premium paid to take on the trade. Additionally, the maximum reward associated with taking on this strategy is the difference between the strike price of the two contracts multiplied by 100 and then subtracting the premium paid to take on the trade.
How to choose the best vertical spread option strategy
If you want to easily find a strategy that will match your trading style, there are three things you should keep in mind. These are:
- The options that you should trade
- When to enter and
- When to exit a trade
What is the difference between credit and debit spreads?
The two legs of the position will determine whether the spread is a credit or a debit. Here is a detailed explanation of how this difference comes about.
Credit VS Debit Spreads
*In a credit spread, the premium you get from selling is more than buying, i.e., a long position. This difference leads to a net short premium position, or you could also call it a credit trade.
So, both a short call spread and a short put spread are credit spreads since the short options have more value than the long options bought to define the risk.
On the other hand, with a debit spread, you find that the premium to purchase (long option) is more costly than the premium from selling (short option). For this reason, the net premium will be a debit.
Both long call and long put spreads are debit spreads as the long options have more value than the short options sold against it to minimize the cost basis.
*Note that the foundations of a credit spread are the short option and net credit received. Further, the credit received in advance will push the breakeven price beyond the strike price.
The long option will define your risk in a credit spread and provide protection against the short option.
On the contrary, the long option is the focal point in a debit spread. You can reduce its (long option’s) cost basis by selling the short option against it. Keep in mind that losing positions in debit spreads are normally not defended since the net premium paid (maximum loss) is known at order entry.
Closing and managing vertical spreads
Let's separate the two situations so you can clearly see what we are discussing.
For all four types of vertical spreads, you should only close them at a more favorable price than the entry price. In most cases, traders use the 50% guideline, i.e., making 50% of the maximum profit as your goal before closing. However, you can take profits at any point during the trade that you feel is most suitable.
If the credit received from a short vertical spread was $220, the closing should be at $110, which is 50% of the maximum profit. And for debit spreads, if the maximum profit was $300, you should strive to close when the spread hits $150.
Managing the spreads
First, you should note that you cannot manage losing long vertical spreads. Instead, you can close them at any point before the expiry date to avoid fees.
The other thing about managing credit spreads is that it can help decrease your maximum possible loss while also increasing your highest potential profit.
As you manage your credit spread, ensure that it does not entirely go ITM, i.e., become an option that has intrinsic value. This is common when your long option has more extrinsic value than your short option.
But if vice versa, i.e., the short option has more extrinsic value than the long option, it is safe to roll out the spread in time for credit. This implies that you will be getting more extrinsic value from the premium received than what you'd be paying in the buying position. The result will be that your maximum loss potential will be reduced while your highest possible profit will increase.
In general, a vertical spread is a strategy that could help reduce risks and costs associated with options trading. We have covered four different types of vertical spread strategies and provided you with the criteria that you can use to choose the one that works for you.
If you get everything right, you are likely to net good profits as well as minimize losses from your trades.
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