- November 25, 2022
- Posted by: CoachShane
- Category: Trading Article
In our first playbook, we shared out criteria for trading calls and puts. In this overview, we will be going over our vertical spreads playbook. I will say that trading option spreads is our top approach for trading in the options market.
What Are Vertical Spreads?
In summary, a vertical Spread is the simultaneous purchase and sale of two options of the same underlying asset, but with different strike prices and the same expiration date. The big two benefits are they are lower cost and have defined risks (the premium you paid).
An example of a long vertical call spread is: Buy 1 ABC September 40 call | Sell 1 ABC September 45 call
For a more detailed look using a vertical debit spread:
ABC stock is trading at $40.00.
We would buy 1 call option for a $40.00 strike price of $3.00. At the same time, we sell 1 call option at the $45.00 strike for $1.00
It would cost us $2.00 to put the trade on (We paid $3 on the buy and collected $1 on the sell).
We have the right to buy 100 shares of ABC stock at $40. We have an obligation to sell 100 shares, if exercised, at $45.
How much can we make on this vertical call?
The maximum we can make on this trade is the difference between the long and short strike ($5.00) minus the debit paid ($2.00) or $3.00 profit.
How much can we lose?
We can only lose the debit paid which is $2.00.
Where is breakeven?
We will be at breakeven when we take the long strike of $40 plus the debit paid = $42.00
When do we use this?
We take these positions when we are bullish, want a cheaper trade, defined risk, and when volatility is low (< 50%).
What do we want to happen?
We want the stock to be right at or above the short strike price at expiration. In our example, this would be $45.00
What about volatility?
You want volatility to rise or at least not go lower while in the trade. Once you hit the short strike then you want volatility to go down.
Long Vertical Put Debit Spread
We will also take bearish positions and to do so, we will long at a vertical put spread.
For a more detailed look:
ABC stock is trading at $40.00.
We would buy 1 put option for a $40.00 strike price of $3.00. At the same time, we sell 1 put option at the $35.00 strike for $1.00.
We have the right to sell 100 shares of ABC stock at $40. We have an obligation to buy 100 shares, if exercised, at $35.
How much can we make?
The most we can make on this trade is the difference between the short and long strike ($5.00) minus the debit paid ($2.00) or $3.00.
How much can we lose?
We can only lose the debit paid which is $2.00.
Where is breakeven?
We will be at breakeven when we take the long strike of $40 and subtract the debit paid = $38.00.
When do we use this?
We take these positions when we are bearish and want a cheaper trade, and defined risk.
What do we want to happen?
We want the stock to be right at or below the short strike at expiration.
Does volatility matter?
We want to see volatility rise or, at the very least, not drop off while in the trade. Once the short strike is hit, we want to see volatility decline.
Insider Tip: When implied volatility is high, consider buying a put spread and not just a put. The spread is selling a put which will help offset, to some degree, implied volatility.
Our Criteria For Long Vertical Spreads
In a perfect world, we want to see implied volatility lower than the 50th percentile (using TOS).
Use the front month if there is at least 20 days left to expiration. If not, then go to the next month out.
We will buy the option one strike ITM. This will allow us to get in by paying as little extrinsic value as possible.
We will then look to sell the next strike OTM.
We can also play around with the strikes to make the spread wider or tighter if we can pay 50% or less of the width of the strikes.
We are targeting 80-100% returns on this trade. We will also look to exit the trade no later than Wednesday of the expiration week if we are still in the trade.
5 Quick FAQs
Vertical spreads are a type of options trade that involves buying and selling two options with different strike prices but at the same expiration date.
Vertical spreads can be either bullish or bearish and are used when an investor is expecting moderate price movement in the underlying security.
Vertical spreads have defined risk and are therefore considered a relatively low-risk trade.
To maximize profits on a vertical spread, traders should aim for an 80-100% return and exit the trade no later than Wednesday of expiration week.
When selecting strikes for a vertical spread, traders should consider implied volatility and look to buy the option one strike ITM and sell the next strike OTM.
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