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Vertical Spreads

All About Vertical Spreads - Definition, An Example, and How to Use

A vertical spread is simply the purchase of an option and simultaneous sale of another option at different strike prices (same underlying security, of course).  A vertical spread is a known as a directional spread because it makes or loses money depending on which direction the underlying security takes.

You buy a vertical spread if you have a feel which way the market for a particular stock is headed.  You can buy a vertical spread if you think the stock is headed higher, or a different vertical spread if you believe it is headed lower.  A neat thing about vertical spreads is that if the stock doesn't move at all, you might just make a gain even if it didn't do exactly what you had hoped.

Here is an example of a vertical spread I recently placed.  I had a good feeling about Apple.  I thought the stock would go up in the next month, or at least not fall very much.  The stock was trading about $200 a share.  I purchased 10 Apple March 190 calls and simultaneously sold 10 Apple March 195 calls and paid out $3.63 per spread ($3653 + $30 commission = $3683).  I only had to come up with the difference between the cost of the option and the proceeds from the option I sold.

I bought this spread with calls, but the potential gains or losses would have been identical if I had used puts instead.  In vertical spreads, the strike prices are what is important, not whether puts or calls are used.

On the third Friday of March, both options would expire.  If the stock is at any price above $195, the value of my vertical spread would be worth $5000 less $30 commissions ($4750), and I would make a gain of $1067 on an investment of $3683, or 29% for a single month of waiting for expiration to come.

The maximum loss of my vertical spread would be my entire investment ($3683) if the stock fell below $190.  I would make a gain at any price above $193.69.  If the stock ended up at $192, my 190 call would be worth $2.00 ($2000) and the 195 would expire worthless.  In that event, I would lose $1683.

If the stock ends up over $195 at expiration, I do not have to place any trade to close out the vertical spread.  The broker will automatically sell the 190 calls and buy back the 195 calls for exactly $5.00, charging me a commission on both options ($1.50 each at thinkorswim where I trade).

I placed this vertical spread because I liked the prospects for Apple and because I would make the maximum gain (29% in a single month) even if the stock fell from $200 down to $195, so I could even be a little wrong about the stock and I would still make the maximum gain.

In retrospect, I would have been smarter to buy the vertical spread using puts rather than calls (if the same price for the spread could have been had).  If I used puts, I would buy at the same strike prices (buying the 190 puts and selling the 195 puts).  I would collect $1.37 ($1370 less $30 commissions, or $1340 because the 195 puts would carry a higher price than the 190 puts that you bought).  When you buy a credit spread like this, the broker places a maintenance requirement on your account to protect against the maximum loss that you could incur.  In this case, a $5000 maintenance requirement would be made, which after the $1340 you collected in cash was credited, would work out to $3660.  This is the maximum you would lose if the stock closed below $190.

A maintenance requirement is not a margin loan.  No interest is charged.  The broker just holds that amount aside in your account until your options expire.

There are several reasons that I would have been smarter to make this trade in puts rather than calls.  First, if Apple closes above $195, both put options would expire worthless, and I would not be charged $30 in commissions to close them out like I will have to with the calls.  Second, selling a vertical (bullish) spread in puts means that I would be taking in more cash than I paid out (i.e., it is a credit spread).  The extra cash in my account would be credited against a margin loan I might have in my account, thus saving me some interest (there is no interest charged on a maintenance requirement).  Third, buying a vertical put spread eliminates the possibility of an early exercise of a short in-the-money call - such an exercise might take place if the company declares a dividend during the holding period of the spread, or if the call gets so far in the money that there is no time premium left, and the owner of the call decides to take stock.

For all these reasons, put spreads are the best bet for vertical spreads when you expect the stock price to rise, assuming, of course, that they can be placed for the same price as the equivalent spread in calls.  The risk profile of each spread is the same, so the least expensive alternative should be taken, and if both put and call spreads are identical, then puts should be the spread of choice.

Terry's Tips Stock Options Trading Blog

August 25, 2015

Now Might Be the Perfect Time to Make This Volatility Trade

Today I would like to pass along a trade I just made. It has a chance of making 50% if the stock stays flat or moves moderately higher over the next ten days. I want to share it with you just in case you might like to try it yourself (with some money you could afford to lose – we’re talking about $670 here, per contract).

Terry

Now Might Be the Perfect Time to Make This Volatility Trade

The market is going crazy. VIX, the so-called Fear Index, skyrocketed to 40 yesterday, something it hasn’t done for over 2 years. It has fallen to about 30 today, and if history is any indicator, it is headed for the 12 – 14 level where it has hung out for . . .

August 17, 2015

How to Fine-Tune Market Risk With Weekly Options

This week I would like to share an article word-for-word which I sent to Insiders this week. It is a mega-view commentary on the basic options strategy we conduct at Terry’s Tips. The report includes two tactics that we have been using quite successfully to adjust our risk level each week using weekly options.

If you are already trading options, these tactic ideas might make a huge difference to your results. If you are not currently trading options, the ideas will probably not make much sense, but you might enjoy seeing the results we are having with the actual portfolios we are carrying out for our subscribers.

Terry

How to Fine-Tune Market Risk With Weekly Options

“Bernie Madoff attracted hundreds of millions of dollars by promising investors 12% a year (consistently, year after year). Most of our portfolios achieve triple that . . .

August 6, 2015

3 Options Strategies for a Flat Market

Before I delve into this week’s option idea I would like to tell you a little bit about the actual option portfolios that are carried out for Insiders at Terry’s Tips. We have 11 different portfolios which use a variety of underlying stocks or ETPs (Exchange Traded Products). Eight of the 11 portfolios can be traded through Auto-Trade at thinkorswim (so you can follow a portfolio and never have to make a trade on your own). The 3 portfolios that cannot be Auto-Traded are simple to do on your own (usually only one trade needs to be made for an entire year).

Ten of our 11 portfolios are ahead of their starting investment, some dramatically ahead. The only losing portfolio is based on Alibaba (BABA) – it was a bet on the Chinese market and the stock is down over 30% since we started the portfolio at the beginning of this year (our loss is much greater). The best portfolio for 2015 is up 55% so far and will make exactly 91% if the three underlyings (AAPL, SPY, and GOOG) remain where they presently are (or move higher). GOOG could fall by $150 and that spread would still make 100% for the year.

Another portfolio is up 44% for 2015 and is guaranteed to make 52% for the year even if the underlying (SVXY) falls by 50% between now and the end of the year. A portfolio based on Costco (COST) was started 25 months ago and is ahead more than 100% while the stock rose 23% - our portfolio outperformed the stock by better than 4 times. This is a typical ratio – portfolios based on Nike (NKE) and Starbucks (SBUX) have performed similarly.

We are proud of our portfolio performance and hope you will consider taking a look at how they are set up and perform in the future.

Terry

3 Options Strategies for a Flat Market

"Thinking is the hardest work there is, which is probably the reason why so few engage in it." - Henry Ford

If you think the market will be flat for the next month, there are several options strategies you might employ. In each . . .

Making 36%

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This book may not improve your golf game, but it might change your financial situation so that you will have more time for the greens and fairways (and sometimes the woods).

Learn why Dr. Allen believes that the 10K Strategy is less risky than owning stocks or mutual funds, and why it is especially appropriate for your IRA.

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