A vertical spread is simply the purchase of an option and simultaneous sale of another option at different strike prices in the same expiration month (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). (As you may know, Apple rose sharply recently, and is now over $220 so it looks like I will be assured of the maximum gain.)
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. 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 on stock 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.
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The market continued its winning ways this past week, albeit a slow, grinding advance. The NASDAQ 100 (QQQQ) made a new 52-week high mid-week while the S&P managed to hit new highs briefly on Friday. The NASDAQ finished the week higher 1.8% while the major market benchmark S&P 500 (SPY) pushed higher 1.0%.
Many market participants attributed the slow move higher to a lack of catalysts due to a thin economic calendar, but others pointed to the 'very overbought' nature of the market as a whole. It is interest to note that the market has pushed the number of stocks showing sharp gains to the highest level since 1994. Is this a sign of more to come?
"While a sign of a short-term overbought condition, which could usher in a pause, readings this extreme have historically led to higher prices over the next several months," John Kolovos and Craig Peskin, technical analysts at Concept Capital, wrote in a note to clients yesterday.
Since February 23rd (the last notable loss for the S&P 500), the market has pushed steadily higher. It market stalwart has advanced 11 out of the last 12 trading days and now the S&P has finally pushed into historical 'very overbought levels. Furthermore, the SPX (S&P 500) has bumped into a strong area of overhead resistance. The highs of the trading range that started back in mid-January (1150 to 1060) are once again being tested so it will be interesting to see how the market reacts during the beginning of next week.
I expect to see a fairly sharp decline over the next few sessions as Mr. Probability is leaning heavily towards the bearish camp over the short-term. Of course, as we all know, there are no certainties in trading. However, it is notable that the S&P 500's current overbought level is the fourth highest since 1990. Also, this past week marked the one-year anniversary of the bear market low. Since then the S&P has advanced 69% from its 12-year low.
Many feel the recent surge lacks conviction. Neil Menard, principal at Steben & Co. in Rockville, Md., stated, "there is a lack of conviction in the markets," he said. "Everyone is kind of in wait-and-see mode." He points to the uncertainty of the job market as the catalyst.
Next week the economic calendar should provide traders with plenty of volatility. The week is full of big reports including Industrial Production, Housing Starts, PPI on Wednesday and CPI on Thursday. However, most of the focus will be given to the Federal Reserve, as the FOMC policy directive is due out Tuesday afternoon. One thing is certain there should be plenty of potential catalysts over the course of next week. Where will the market go? One thing is certain, we will find out soon enough.
Andy
Overbought/Oversold as of March 15, 2010
Major Benchmarks