THE OPTIONS COURSE- Introducing Vertical Spreads

THE OPTIONS COURSE


Introducing Vertical Spreads

Since all markets have the potential to fluctuate beyond their normal trend, it is essential to learn how to apply strategies that limit your losses to a manageable amount. A variety of options strategies can be employed to hedge risk and leverage capital. Each strategy has an optimal set of circumstances that will trigger its application in a particular market. Vertical spreads are basic limited risk strategies, and that’s why I tend to introduce them first. These relatively simple hedging strategies enable traders to take advantage of the way option premiums change in relation to movement in the underlying asset.

Vertical spreads offer limited potential profits as well as limited risks by combining long and short options with different strike prices and like expiration dates. The juxtaposition of long and short options results in a net debit or net credit. The net debit of a bull call spread and a bear put spread correlates to the maximum amount of money that can be lost on the trade. Welcome to the world of limited-risk trading! However, the net credit of a bull put spread and a bear call spread is the maximum potential reward of the position—a limited profit. Success in this kind of trading is a balancing act. 

You have to balance out the risk/reward ratio with the difference between the strikes—the greater the strike difference, the higher the risk. One of the keys to understanding these managed risk spreads comes from grasping the concepts of intrinsic value and time value—variables that provide major contributions to the fluctuating price of an option. Although changes in the underlying asset of an option may be hard to forecast, there are a few constants that influence the values of options premiums. The following constants provide a few insights into why vertical spreads offer a healthy alternative to traditional bullish and bearish stock trading techniques:

• Time value continually evaporates as an option approaches expiration.
• OTM and ATM options have no intrinsic value—they are all time value and therefore lose more premium as expiration approaches than ITM options.
• The premiums of ITM options have minimum values that change at a slower pace than OTM and ATM options.
• Vertical spreads take advantage of the differing rates of change in the values of the options premiums.

The four vertical spreads that we use can be broken down into two kinds of categories: debit and credit spreads, each with a bullish or bearish bias. The success of these strategies depends on being able to use options to exploit an anticipated directional move in a stock. As usual, timing is everything. To become good at forecasting the nature of a directional trend, try to keep track of a stock’s support and resistance levels. Remember, a breakout beyond a stock’s trading range can happen in either direction at any time. Limiting your risk is a great way to level the playing field.

VERTICAL SPREAD MECHANICS

Vertical spreads are excellent strategies for small investors who are getting their feet wet for the first time. Low risk makes these strategies inviting. Although they combine a short and a long option, the combined margin is usually far less than what it would cost to trade the underlying instrument. If you are new to the options game, take the time to learn these four strategies by paper trading them first. There are two kinds of debit spreads: the bull call spread and the bear put spread. As their names announce, a bull call spread is placed in a bullish market using calls and a bear put spread is placed in a bearish market using puts. 

Debit spreads use options with more than 60 days until expiration. The maximum risk of a debit spread is limited to the net debit of the trade. In contrast, the maximum profit of a credit spread is limited to the net credit of the trade. There are two kinds of credit spreads: the bull put spread and the bear call spread. The bull put spread is placed in a bullish market using puts and a bear call spread is placed in a bearish market using calls. In general, credit spreads have lower commission costs than debit spreads because additional commissions are avoided by simply allowing the options to expire worthless. 

TABLE  Vertical Spread Definitions


Since credit spreads offer a limited profit, make sure that the credit received is worth the risk before placing the trade. To determine which strategy is the most appropriate, it is important to scan a variety of strike prices and premiums to find the optimal risk-to-reward ratio. This is accomplished by calculating the maximum risk, maximum reward, and breakeven of each potential spread to find the trade with the best probability of profitability. Choosing the type of trade (debit or credit) depends on whether you prefer to pay for a trade out-of-pocket or take the credit and ride the bear or bull all the way to expiration.

BULL CALL SPREAD

The bull call spread, also called the long call spread, is a debit strategy created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. The shortest time left to expiration often provides the most leverage, but also provides less time to be right. This strategy is best implemented in a moderately bullish market. Over a limited range of stock prices, your profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying asset. However, the total investment is usually far less than the amount required to buy the stock shares. The bull call strategy has both limited profit potential and limited downside risk.

The maximum risk on a bull call spread is limited to the net debit of the options. To calculate the maximum profit, multiply the difference in the strike prices of the two options by 100 and then subtract the net debit. The maximum profit occurs when the underlying stock rises above the strike price of the short call causing it to be assigned and exercised. You can then exercise the long call, thereby purchasing the underlying stock at the lower strike price and delivering those shares to the option holder at the higher short price. The breakeven of a bull call spread is calculated by adding the net debit to the lower strike price.

Choosing the Options

In order to choose the options with the best probability of profitability for a debit spread, it is important to balance out four factors:

1. The options need at least 60 days until expiration in order to give the underlying stock enough time to move into a profitable position.
2. Keep the net debit as low as possible to make the trade worthwhile.
3. Make the difference in strikes large enough to handle the net debit so that the maximum profit is worthwhile.
4. Make sure the breakeven is within the trading range of the underlying shares.

Bull Call Spread Mechanics

With XYZ trading at $51, let’s create an example by going long 1 XYZ September 50 Call @ 3.50 and short 1 XYZ September 55 Call @ 1.50. The difference between the premium for the long 50 call and the credit received from the short 55 call leaves a net debit of 2 points. The maximum risk for this trade is the debit paid for the spread, or $200: (3.50 – 1.50) × 100 = $200. The maximum reward for the trade is calculated by subtracting the debit paid from the differences in the strike: [(55 – 50) – 2] × 100 = $300.

The breakeven on this strategy occurs when the underlying asset’s price equals the lower strike plus the net debit. In this case, the net debit is 2 points, so the breakeven is 52: (50 + 2 = 52). Thus, the trade makes money (theoretically) as long as the underlying asset closes above 52 by expiration. The risk profile for a bull call spread visually reveals the strategy’s limited risk and profit parameters. Notice how the maximum profit occurs at the short call strike price.

To find a market that is appropriate for placing a bull call spread, look for any markets that are trending up nicely or have reached their support level and are poised for a rebound. Your intention is for the market to rise as high as the strike price of the short call. That way, if the short call is exercised early, you can make the maximum return on the trade by exercising the long call and pocketing the difference.

FIGURE  Bull Call Spread Risk Graph

Exiting the Position

To exit a bull call spread, it is important to monitor the daily price movement of the underlying stock and the fluctuating options premiums. Let’s explore what happens to the trade in the following scenarios:

XYZ rises above the short strike (55): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $55 a share. By exercising the long call, you can buy 100 shares of XYZ at $50 a share and pocket the difference of $500 (not including commissions). By subtracting the cost of the trade ($200), the net profit on the spread is $300—the maximum profit available.
XYZ rises above the breakeven (52), but not as high as the short strike (55): Offset the options by selling a 50 call at a profit and buying a 55 call back at a slight loss, pocketing a small profit.
XYZ remains below the breakeven (52), but above the long strike (50): Sell a 50 call at a profit and buy a 55 call at a loss, pocketing a small profit; or wait until expiration and sell the long call at a slight profit to offset the trade’s net debit and let the short option expire worthless.
XYZ falls below the long strike (50): Let the options expire worthless, or sell a 50 call prior to expiration to mitigate some of the loss.

Bull Call Spread Case Study

A bull call spread is used when a trader is moderately bullish on a stock or index. By using a spread, the up-front cost to enter the trade is lower, but the offset is that the maximum reward is limited. Even so, when we expect to sell a stock at a given price anyway, it makes sense to lower the cost and thereby limit the risk to a manageable amount. A bull call spread consists of buying a call and selling a higher strike call. The sale of the higher strike call brings in premium to offset the cost of buying the lower strike call. What we then have is a limited risk, limited reward strategy.

On October 24, 2003, the Semiconductor HOLDRS (SMH) put in a bottom formation. This was a good time to enter a bull call spread on SMH shares, looking for about a 6-point move in the shares. As of the close on this day, SMH shares were priced at $38.55. The January 40 calls could be purchased for $2.05 and the January 45 call could be sold for $0.50. This left us with a debit of $1.55 a contract to enter a bull call spread.  When trading a bull call spread, it’s best to see a 2-to-1 reward-to-risk ratio. 

This trade meets this qualification. The maximum reward is calculated by subtracting the net debit (1.55) from the difference between strikes (45 – 40 = 5) and then multiplying this number by 100. Thus, the maximum reward on this trade is $345: (5 – 1.55) × 100 = $345. By entering five contracts, this trade would have cost $775, with a maximum reward of $1,725. The breakeven point is found by adding the net debit to the lower strike price. In this case, the breakeven is 41.55: (40 + 1.55 =41.55). On November 7, 2003, shares of SMH closed at $43.99 after trading slightly higher during the session. 

FIGURE  Risk Graph Of Bull Call Spread on SMH

Since $44 was our price target, we could have sold on this day for nearly a 100 percent profit. The January 40 call could be sold for $5.30 and the January 45 call could be purchased back for $2.40. This equates to credit of $2.90 a share, but we then need to subtract the initial debit of $1.55. Thus, our total profit was $135 a contract, or $675 overall. Though buying a call outright would have created a larger profit, the risk also would have been greater. If SMH shares had fallen lower following the entry into this trade, a bull call spread would have seen a much smaller loss than a straight call.

BEAR PUT SPREAD

A bear put spread, or long put spread, is a debit spread that is created by purchasing a put with a higher strike price and selling a put with a lower strike price. Both options must expire in the same month. This is a bearish strategy and should be implemented when you expect the market to close below the strike price of the short put option—the point of maximum reward (at expiration). This high-leverage strategy works over a limited range of stock and futures prices. 

Your profit on this strategy can increase by as much as 1 point for each 1-point decrease in the price of the underlying asset. Once again, the total investment is usually far less than that required to short sell the stock. The bear put spread has both limited profit potential and limited upside risk. Puts with the shortest time left to expiration usually provide the most leverage, but also reduce the time frame you have for the market to move to the maximum reward strike price.

The maximum risk of a bear put spread is limited to the net debit of the trade. The maximum profit depends on the difference in strike prices minus the net debit. It is important to find a combination of options that provides a high enough profit-to-risk ratio to make the spread worthwhile.

Bear Put Spread Mechanics

With XYZ currently trading at $56, let’s create a bull put spread by going long 1 XYZ September 55 Put @ 2 and short 1 XYZ September 50 Put @ .50. The difference between the long 55 put premium of 2 ($200) and the credit received for the short 50 put (.50 or $50) is a net debit of $150. The net debit is the maximum risk for a bear put spread. The maximum reward for the trade is calculated by subtracting the net debit paid from the difference between strike prices: (55 – 50) – 1.50 × 100 = $350. Even though the reward is limited to $350, the sale of the 50 put has lowered the breakeven on this position. 

The breakeven occurs when the underlying asset’s price equals the higher strike price minus the net debit. In this case, the breakeven would be 53.50: (55 – 1.50 = 53.50).  The risk profile of a bear put spread slants upward from right to left, displaying its bearish bias. Once the underlying stock falls to the price of the short put, the trade reaches its maximum profit potential. Conversely, if the price of the underlying stock rises to the strike price of the long put, you will lose the maximum limited amount. Once again, it is important to monitor this trade for a reversal or a breakout to avoid losing the maximum amount.

Exiting the Trade

To exit a bear put spread, you have to monitor the daily price movement of the underlying stock and the fluctuating options premiums. Let’s explore what you can do to profit on a bear put spread if one of the following scenarios occurs.


FIGURE  Bear Put Spread Risk Graph

XYZ falls below the short strike (50): The short put is assigned and you are obligated to purchase 100 shares of XYZ from the option holder at $50 a share. By exercising the long put, you can turn around and sell those shares at $55 a share and pocket the difference of $500. By subtracting the cost of the trade ($150), the profit on the spread is $350—the maximum profit available.
XYZ falls below the breakeven (53.50), but not as low as the short strike (50): Offset the trade by selling a 55 put at a profit and buying a 50 put at a loss, pocketing a small profit.
XYZ remains above the breakeven (53.50), but below the long strike (55): Sell a 55 put at a profit and buy a 50 put at a loss, pocketing a small profit, or wait until expiration and sell the long put at a slight profit to offset the trade’s net debit and let the short option expire worthless.
XYZ rises above the long strike (55): Let the options expire worthless, or sell the 55 put at expiration to mitigate some of the loss.

Bear Put Spread Case Study

A bear put spread is used when a trader is moderately bearish on a stock or index. By using a spread, the up-front cost to enter the trade is lower, but the offset is that the maximum reward is also lower. Even so, when we expect to cover short stock at a given price anyway, it makes sense to lower our cost. A bear put spread consists of buying a put and selling a lower strike put. 

The sale of the lower strike put brings in premium to offset the cost of buying the higher strike put. What we then have is a limited risk, limited reward strategy. On June 5, 2003, shares of Cigna (CI) were showing bearish tendencies. The stock closed the session on June 5 at $52 and a trader might have anticipated a move lower to support near $40. 

The move was expected to occur within the next few months, so a trader could have used the October options. By purchasing a 50 put and selling a 40 put, the trader would have entered a bear put spread for a total of $3.05 per contract. The long put would have cost $4.00 and the short put could have been sold for $0.95. In this case, let’s assume the trader decides to place a trade for five bull call spreads. 

Just like a bull call spread, we want to see a reward-to-risk ratio of at least 2-to-1. For this trade, the maximum risk is the initial debit of $305, or $1,525 for 5 contracts. The maximum reward is calculated by subtracting the debit (3.05) from the difference in strike prices (50 – 40 = 10). Thus, the maximum reward of this trade is $695: (10 – 3.05) × 100 = $695 per contract, or $3,475 for all five contracts. This creates a reward-to-risk ratio of 2.28 to 1 (6.95/3.05).


FIGURE  Risk Graph of Bear Put Spread on CI 

On July 15, 2003, shares of CI closed at $41.04, leaving this trade with a very nice gain. Though the price target of $40 hadn’t quite been reached, the trade was up more than 100 percent and this would have been a good time to take profits. The October 50 put could be sold for $9.50 and the October 40 put could be purchased back for $2.70. This equates to a credit of $6.80 a share, but we then need to subtract out the initial debit of $3.05.

Thus, our total profit was $3.75 a share, $375 a contract, and $1,875 for all five contracts—a gain of 123 percent. Though buying a put outright would have created a larger profit, the risk also would have been greater. If CI shares had risen following the entry into this trade, a bear put spread would have seen a much smaller loss than a straight put.

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