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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

April 26, 2016

Last Minute Facebook Earnings Play

Facebook (FB) announces earnings tomorrow, Wednesday the 27th, after the close. There is still time to place what I think will be a dynamite options play. You have until the close tomorrow to get these spreads in place.

Terry

Last Minute Facebook Earnings Play

Over the past few weeks, I have suggested legging into calendar spreads at a price slightly above the current stock price for companies that would be announcing earnings about two or three weeks later. The underlying idea of these spreads is that, 1) in the days leading up to the announcement, the stock tends to drift higher as hope for a positive announcement grows and, 2) implied volatility (IV) of the option series that expires directly after the announcement date almost always soars because big moves in the stock often take place right after results are disclosed.

In my personal account, in the last few weeks, I have both told you about and used this strategy for SBUX, JNJ, and FB. In each case, I bought a slightly out-of-the-money call a few weeks out and . . .

April 20, 2016

How to Play the Upcoming Facebook Earnings Announcement

Over the last 3 weeks, I have suggested a way to leg into calendar spreads at a credit in advance of the earnings announcement for Starbucks (SBUX), Facebook (FB), and Abbvie (ABBV). All three calendars ended up being completed, and all three have already delivered a small profit. Once earnings are announced and the short side of the calendar spread expires, all three spreads are guaranteed to produce a much larger profit as well (depending on how close the stock price is to the strike price).

Today I would like to discuss another Facebook play. While this one does not guarantee profits, I believe it is even more exciting in many ways. It is possible that you could double your money in less than two weeks. I also believe it is extremely unlikely to lose money.

Terry

How to Play the Upcoming Facebook Earnings Announcement

All sorts of articles have been written over the past few weeks about the prospects for FB, some positive and some negative. We will all learn who was right and who was wrong late next week when FB announces earnings on April 27, and the details of the company’s large assortment of new and wondrous initiatives will be disclosed.

The high degree of uncertainty over the announcement has caused implied volatility (IV) of the options to soar, particularly in the series that expires two days after the announcement. Those Apr5-16 options carry an IV of 52. This compares to only 35 for longer-term option series and 32 for the Apr4-16 series which expires this week.

Buying calendar spreads at this time represents one of the best opportunities I have ever seen to buy cheap options and sell expensive options against them. The FB calendar spreads are exceptionally cheap right now, at least to my way of thinking.

I have written an article which was published by TheStreet.com today which describes the actual calendar spreads I have bought yesterday and today (and I have bought a lot of them). The article fully explains my thinking as to which spreads I purchased. Read the full article here.

April 12, 2016

Earnings Season Has Arrived – How to Capitalize on it With Options

For each of the last two Mondays I have told you about an earnings-related trade I made. Today I would like to review my thinking on those trades, update how they are going, and offer you a new idea of a third trade I made his morning.

Terry

Earnings Season Has Arrived – How to Capitalize on it With Options

In the last few weeks leading up to a quarterly earnings announcement, two things usually happen. First of all, the stock often moves higher as the announcement day approaches as some investors start hoping that the company might beat expectations. The second thing is even more likely (and essentially always happens). Implied Volatility (IV) of the option prices moves much high. This means that the prices for options temporarily rise in value across the board. The greatest upward move in IV takes place in the options series which expires just after the announcement date.

The reason that IV becomes greater at this time is that once earnings are announced, the stock is likely to move either up or down by a much larger amount than it does most trading days. When volatility is . . .

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