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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

March 18, 2018

Nvidia (NVDA) Is on the Verge of a Big Breakout

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 Terry’s Tips portfolio that trades these spreads in an actual account for subscribers to follow on their own or have trades made for them in their account through the free Auto-Trade service offered by thinkorswim has gained 79% so far in 2018.


Nvidia (NVDA) Is on the Verge of a Big Breakout

Several analysts have an optimistic outlook towards NVDA despite the stock trading near some important resistance.  Here are two of them – Things Are Going Right for NVIDIA and AMD and Semiconductor Stocks Soar to Highest Level in Decades Despite Deal Woes.

March 12, 2018

Will Paypal (PYPL) Continue Its Upward Momentum?

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 at Terry’s Tips where we place the trades we tell you about a couple of days later is now ahead 84% so far in 2018, and that includes our closing out the BABA spread last week at a slight loss when we could have made the max gain if we had waited three more days until expiration.  Even we make bad trades once in a while (although we still believe we made the prudent move – no one could have predicted that BABA would soar $11 in the last three days before expiration).


Will Paypal (PYPL) Continue Its Upward Momentum?

Several articles have recently been published on the positive outlook for PYPL.  Here are two of them – Paypal Holdings Stock Is Itching for a Breakout and BMO Capital Markets Boosts Paypal Price Target to $89.00.

March 5, 2018

TD Ameritrade (AMTD): A Stable and Consistent Player

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.


TD Ameritrade (AMTD): A Stable and Consistent Player

Several analysts have a bullish outlook for TD Ameritrade, here are two of them: TD Ameritrade Rating Reiterated by Goldman Sachs Group and TD Ameritrade PT Raised to $61.00

AMTD faced some volatile price action in February as the global equity markets fell under pressure and broadly corrected lower.  In the past week, AMTD broke to a fresh 19 year high prior to pulling back.  The bullish break is suggesting the stock has resumed higher within its broader uptrend while the pullback offers an entry point against support from the 20-period daily moving average.

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