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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

September 23, 2018

Consider Buying the Post-Earnings Dip in Adobe Systems (ADBE)

This week we are looking at another of the Investor’s Business Daily (IBD) Top 50 List companies.  We use this list in one of our options portfolios to spot outperforming stocks and place option spreads that take advantage of the momentum.

Terry

Consider Buying the Post-Earnings Dip in Adobe Systems (ADBE)

Adobe’s stock price has seen a steady rise over the last few years, and from both a technical and fundamental standpoint, there is a strong case to be made that it will continue.  These following two articles discuss the recent earnings report and where the stock may go from here - Adobe: Stock Marches Forward With Another Record Quarter and Should You Buy Adobe Systems at Its All-Time High?.  As well, there have been several price target upgrades as of late and a few of the more bullish analysts think the stock can even cross above the $300 price point.

September 15, 2018

Has Netflix (NFLX) Found A Bottom?

This week we are looking at another of the Investor’s Business Daily (IBD) Top 50 List companies.  We use this list in one of our options portfolios to spot outperforming stocks and place option spreads that take advantage of the momentum.  The actual portfolio that Terry’s Tips carries out with these plays we send to you each week has gained 98.5% so far this year.  We started out 2018 with $5000 in the portfolio and withdrew that amount in June so that subscribers who mirrored it in their own account or had trades executed for them with the free Auto-Trade service at thinkorswim have almost $5000 left and it is entirely profits for them.

Terry

Has Netflix (NFLX) Found A Bottom?

Despite a recent correction, market sentiment towards Netflix stock remains positive while certain analysts see a notable upside from current levels.  Take a look at this recent article posted on Investopedia that states a 30% rally could be in the cards for NFLX and the following article posted on Seeking Alpha that builds a strong case for remaining bullish.

September 10, 2018

Mastercard (MA) Expected to Continue the Steady Rise

This week we are looking at another of the Investor’s Business Daily (IBD) Top 50 List companies.  We use this list in one of our options portfolios to spot outperforming stocks and place option spreads that take advantage of the momentum.

The actual Terry’s Tips portfolio which trades essentially every weekly play that we send to you has gained 91% so far this year (after paying all commissions, of course).  The portfolio started out the year with $5000, and on June 15, 2018, we withdrew $5000 from the portfolio so that all subscribers who followed it would all their money back and be playing with pure profits.  The portfolio is now worth $4552.

I especially like this week’s idea because I like Mastercard and believe that last week’s weakness in the stock price was unwarranted.  Enjoy the full report below.

Terry

Mastercard (MA) Expected to Continue the Steady Rise

Among the list of IBD Top 50 companies Mastercard stands out as its uptrend is far steadier than any of the other companies.  These two articles suggest the stock will continue the trend – Mastercard’s Stock May Have Big Gains Ahead and Mastercard’s Strategy Suggests Further Stock Price Growth Ahead After 60% Rise.

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