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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

July 29, 2014

3% a Week Possible With This Strategy?

Today I would like to share a strategy with you that seems to make sense to me. I have not back-tested it, and I am not exactly positive that it will work. But I think it will. And I will only need to commit $1500 to test it out (actually, a little less than that as you will see). I invite you to follow along if you wish. For the next few weeks, I will send out any trades I make so you can mirror them if you wish.

My gut feeling tells me that this strategy could make 3% each week. I have set up a separate brokerage account with $1500 to test it out.

Terry

3% a Week Possible With This Strategy? This strategy is based on my favorite . . .

July 21, 2014

Finding Lessons in a Trade

Last week I told you about a bullish short-term bet we made on SVXY because the stock had dropped over $3 in the previous week (and historically, 4 out of 5 times when that happened earlier this year, the stock rose at least $3 in the subsequent week). We placed an order to sell half the calls if they had doubled in price, and that occurred on Tuesday. On Thursday, volatility soared due to the plane being shot down over Ukraine and Israel invading Gaza. It looked like we would just break even on the trade since we had recovered the initial investment, but then, on Friday, the stock rallied $6 and we were able to sell the remaining half for enough to give us a 32% gain on the trade. Not as much as we had originally hoped, but a gain of any sort is always welcome.

Terry

Finding Lessons in a Trade

The big lesson from our experience last week, one that we have had many times, is that there is . . .

July 14, 2014

A Possible Great Option Trading Idea

Just before the close on Friday, we made a strongly bullish trade on our favorite underlying stock in a portfolio at Terry’s Tips. In my personal account, I bought weekly calls on this same underlying. As I write this in the pre-market on Monday, it looks like that bet could triple in value this week.

I would like to share with you the thinking behind these trades so next time this opportunity comes up (and it surely will in the near future), you might decide to take advantage of it yourself.

Terry

A Possible Great Option Trading Idea: As we have discussed recently, option prices are . . .

Making 36%

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