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Short Vertical Spread Strategy - Page 2

Risk of early assignment

In a short vertical spread, what happens if on or near expiration, the stock price is sitting between my short and long options? That means I am ITM on the short option and OTM on the long option. The chance is high that the holder of the option I sold will exercise it, especially as I get close to expiration. In fact if I hold that position all the way to expiration, the broker will do it for them. What will happen then?

If I have a call vertical spread and the holder exercises the call I sold them, I will be forced to sell them the underlying stock at the strike price I sold. If I don't already own the stock, then I will end up with a short position. If this happens on expiration, the option I bought will expire worthless. I will then be left short a stock position of 100 shares for each contract I sold.

The first time this happens to you, it is rather frightening. Don't panic! The best thing to do is buy to cover your short position as soon as possible. If this happens, you may want to have your broker assist you.

If I am short a put vertical spread and the stock is between the short and long strike on expiration, I will be forced to buy the stock at the short strike price. I may not have enough free cash in my account to perform this transaction so I will definitely want to take appropriate action.

The first time this happens to you, contact your broker to discuss how best to handle this. They will direct you to the best course of action.

In either case, if I am fully in the money on both strikes on expiration day, your broker will take care of this for you.

This is one reason I prefer to exit the trade early if I can. See Trade Exits below for more.

Placing the order

When selecting the number of contracts to order, there are two approaches. I could go with the maximum loss amount (i.e. the difference between the two strike prices minus the credit). Alternatively, I could also use the maximum loss amount I am willing to tolerate before closing the trade. I talk about this below under exit strategy #5. If I size my position according to a planned early exit, then I MUST be disciplined to follow through either by using a stop loss or exiting manually.

In the example I've been using, the maximum loss would be $2.50 - $.65 or $1.85 (or $185 for every contract). If I am willing to risk $1000 total, then I can only sell about 5 contracts ($1000/$185).

To trade vertical spreads, many brokers require you to be approved for level 3 trading authority, which gives you the right to trade a variety of different spreads. Before you begin trading spreads, you may want to check with your broker to make sure you are approved.

Most options brokers support placing a vertical spread order simultaneously. While you can place this as two separate orders, I don't recommend it. Too much can happen between the two orders that affect the net credit you receive.

Some online brokers designate opening orders differently than closing orders. Let's say using the above chart, I want to sell the March 27.50 call and simultaneously buy the March 30 call. I might place the combination vertical spread order as 'buy to open 1 contract of the March 30 JPM call for $.90 offer and simultaneously sell to open 1 contract of the March $27.50 JPM call for $1.55 ask'. With this order, either both get filled or neither get filled. If I am filled, I will net a $.65 credit and $250 will be held in margin in my account.

Why is $250 held in margin? Even though I received $.65 credit ($65/contract), my broker knows that if the worst happens, that spread will cost me $250/contract so they set it aside as margin. One way to look at this is that only $185 of my own money was put up in margin with the other $65 coming from the credit.

Once I'm in the trade, I just sit back and let time do it's work. Every day that goes by with the stock going nowhere or even moving in my projected direction, I see the value melting away and my profit increasing.

Trade Exit

With a short vertical spread, there are a few different ways to handle exits. Due to the nature of a short vertical spread, I could just let it expire and realize either the maximum gain or the maximum loss. But... what about the scenario I outlined above where the options expire with the stock somewhere between the two strike prices? What if I don't want to wait until expiration to close the trade, either to lock in existing profit or limit my loss?

There are actually several exit strategies that can be implemented with a short vertical spread.

  1. Do nothing and let the spread expire worthless - I keep the full credit
  2. Do nothing and let the spread expire completely ITM - I pay the max loss on the spread
  3. Absolute close at 4-10 days prior to expiration regardless of gain or loss
  4. Close the trade early when some % of profit realized - I keep some percentage of the original credit
  5. Close the trade early when planned loss amount is realized - I don't lose the complete max loss but pay more to close the trade than I received to open the trade
  6. Close early when a technical target has been reached

These last three options are worth exploring a little further.

Closing early to lock in profit

In the case of early exit to lock in profit, realize that as time goes by and/or the stock moves in the intended direction, the price of the spread decreases. That means it would cost me less to buy it back than I received initially. I might determine that when 80% of my initial credit can be locked in, I'll close. In this case, 80% of $.65 is $.52. That means if I can close the spread by only paying $.13, I will have realized a net profit on the trade of $.52 or 80% of the original maximum gain.

Why would I close the trade early? First of all the only practical way of realizing the max gain is to have the spread expire worthless. What if I could close the trade for the 80% gain with 2 or 3 weeks remaining in the option cycle month? I've freed up the margin for another trade.

Look at it another way. I may not mind allocating $185 in margin to realize $65 in profit, but is it worth keeping that money tied up for the last $13? I've had too many situations where I've had at least 80% of the profit realized but decided to wait only to have the stock turn completely around and experience the maximum loss.

I recommend picking a profit percentage that you will close the trade for and sticking with it.

Closing early to limit loss

I don't have to experience the maximum loss on the trade. I may exit early for several reasons.

  1. Because the stock suddenly changes directions
  2. Because I don't want to lose the entire maximum loss

The first case is harder to determine because technical analysis is somewhat subjective. Unless you are consistent and ruthless in your analysis, you will likely stay in too long. I've found that to be the case for me so I usually go with the second case...

I like to limit my loss to an amount equivalent to the credit I received. That means if I took in a credit of $.65 to open the spread, I'll close it out if the price of the spread reaches $1.30. I have to give back the initial $.65 I received plus I give back another $.65 that I am willing to lose. This would represent a 100% loss.

Closing when a technical target is reached

You do not have to wait until one of your orders triggers to close a trade. It is really nice to have a set of absolute exits in mind but you also need to use your own judgment. If you enter a trade and it goes as planned and you see the potential for a reversal (i.e. price target hit), then exit early.

It is better to keep some of the gains rather than give them all back, or worse... have a winning trade turn into a losing trade.

Just remember... if you decide to exit on your own, make sure you close any contingent or OCO (one cancels other) orders you may have open.

Putting it all together...

My preference for this kind of trade is to have a pre-planned exit if the trade goes well and an exit if the trade goes bad.

I call it my 80%/100% plan. I'll exit when I can lock in 80% of the initial credit OR I'll close if I stand to lose 100% of the initial credit (i.e. it costs twice the initial credit to close the spread).

With this approach I know even before entering the trade how much I will make and how much I could lose. That allows me to chose a position size that I can live with.

Some options brokers will allow you to place a one cancels other trade. You may want to check your broker on whether they support stop losses on a spread. That's the only way to implement an automatic close on a spread with a limited loss. If you can't then you really must be ruthless about following your rules. Use an alert or monitor daily. If you feel you can't put this kind of close in place, then you must size your position for the maximum loss.

Summary

With a short vertical spread or credit spread, time is my friend... and trend can help. Hopefully, you can see that even if the stock, ETF or index goes nowhere, up a little to a lot... or even down a little, you can make money on this trade. When you can make money and be a little wrong, your odds of being successful overall go up tremendously.

That's why this is my favorite strategy.

One final comment...

Notice that as I've discussed the various steps to trading the vertical spread, I've followed a fairly structured approach (selecting the right stock, timing the entry, selecting the right options, entry, exit, etc). These are based on a set of trading rules I follow, which are part of an overall option trading system I follow. This is a key point to make. I've found I can't be successful trading any strategy just by knowing the mechanics. Having a system that defines what I do every time I trade is what helps me be consistent in my profits.

Note: Be sure to check out the Vertical Spread Tutorial on my Youtube channel.

Outlook: Near term to bullish (short put vertical spread) or bearish (short call vertical spread)
Max profit: Limited to the credit received
Max Loss: Difference between the strike prices of the spread and the credit received. You can limit further with a stop loss or early exit.
Net Position: Short
Time decay effect:  Works in your favor
Volatility effect: Benefits from a decrease in volatility


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