Short Vertical Spread Strategy

The short vertical spread is my favorite strategy. Maybe it's just because I receive the credit up front... or maybe it's the combination of pure time value melting away plus the limited risk associated with this trade that appeals to me.

Construction Made up of 1 long option and one short option same month. The short strike will be closer to the ATM price while the long strike price will be further OTM.
Example Long 38 call + Short 36 call

Short 30 put + Long 28 put
Characteristics
  • Put on for a credit
  • Benefits from time passing
  • Benefits from decreasing volatility
  • Defined risk trade
Max profit Credit received on sale of the spread
Max loss The difference between the two strike prices minus the credit

A short vertical spread can be built with either two puts or two calls. This combination is sometimes referred to as a credit spread because the net result of the trade produces a credit. Why does it produce a credit?

With the short vertical spread, the sold strike is closer to the current price of the underlying stock, ETF or index, while the purchased strike is farther away. For either puts or calls, a strike closer to the current price will always have higher premium than the strike that is farther away.

JPM short vertical spread example

In this example, I buy the $30 call and sell the $27.50 call. I can sell the $27.50 call for $1.55, however to buy the $30 call will cost me $.90, leaving a net credit of $.65.

The two key benefits of this strategy to me are:

  1. Defined risk, which I'll cover later in this section
  2. Time decay is in my favor

Let's now take a look at when and how to use this particular strategy.

Outlook/Analysis

This strategy can be used with either a mildly bullish outlook or mildly bearish outlook. If you were bullish, you would use a short put vertical spread (sometimes called a bull put spread). If you were bearish you would use a short call vertical (sometimes called a bear call spread).

"Wait a minute", you might say, "Aren't calls for bullish trades and puts for bearish trades?" The answer is... sort of.

If I was bullish, I could buy a call (long call). However, I could also sell a put (remember the selling puts strategy?)

The short put spread is similar to the naked put strategy except that I have built in limited risk and I typically don't want to own the stock... just collect premium.

A key point to remember is that when you are short an option, you usually have the opposite expectation from the person who is long the option. If I sell a short call spread, what do I want to have happen? I'd like the stock to stay BELOW my short call right? Otherwise I might get assigned.

Trade Entry


Selecting the right stock

Additional Vertical Spread Links

Trade Tutorials
Put Credit Spread (SPY) - Textbook trade
Call Credit Spread (DIA) - Trade management
Call Credit Spread (SPY) - $1 wide vs $2 wide

Videos
Vertical Spreads Pt1
Vertical Spreads Pt2
Mastering Short Vertical Spreads training video

Prior to deciding on the trade, I will likely a particular stock, ETF or index in mind (or maybe a several from my watchlist). By the way, with this strategy, I like to use index options and ETF options. No matter what underlying instrument you chose, you need to make sure of your analysis.

I only trade a bullish spread on a stock that I currently have a bullish bias on. Likewise, I'll only trade a bearish spread on a stock I am bearish on. Whether I arrive at that conclusion via technical analysis or just observing the trend, I believe my odds of success are better trading with my bias, not against it.

This may seem obvious, I've seen people attempt to sell a put vertical spread trying to catch the bottom of a bearish trend or sell a call vertical spread trying to catch the top. OK, I'll admit it... I've been guilty of this as well. However, this is a recipe for money flowing out of your account - not in.

One other item that is important to me is volume of the underlying stock, ETF or index. Usually if the underlying volume is not very high, the options volume and open interest wont' be very high either. So, I look for and prefer a highly liquid underlying instrument.

Timing the entry

Entry timing isn't as critical with the short vertical spread as it may be with other strategies, such as long calls or long put. However, I find two key benefits of properly timing my entry.

  1. I often realize a larger initial credit
  2. I often find I increase my chances of success
The combination of these two benefits mean that I am more consistently profitable.

There are a many possible technical indicators that can be used. If you have your favorites, by all means use them.  But use them consistently!

Here are a few of mine.
  • Bullish entry from a bull flag breakout - or bearish entry for bear flag breakout
  • Bullish entry when stochastic & MACD are in the lower reversal zone - bearish entry when stochastic & MACD are in the upper reversal zone
  • Bullish entry on bounce off support on an up trending stock - bearish entry on similar bounce down from resistance on a down trending stock
JPM Vertical Spread Technical entry
Here is an example of taking an entry from a resistance bounce on a stock that is already in an established longer term downtrend.

This is an ideal entry, however finding that perfect bounce can be difficult. In fact knowing it is a bounce when it happens is tricky.

Look for confirmation such as a move below the low of the prior day to confirm.





Selecting the right options

Once I've chosen my underlying instrument, I like to make sure that I am working with a set of options that have sufficient open interest and volume. Otherwise, I may not get ideal fill prices. I try to make sure my order does not make up more than 5% of the total open interest - that should be true for each leg. Any higher and I run the risk of affecting prices with my order. If I see open interest in the 100's then I'm usually fine.

For the short vertical spread, I also want to select an option month with between 20 and 40 days left of time. This ensures that I'll have enough time premium that will melt away. Selling less than 20 days of premium often results in taking too much risk for too little premium.

Next, I chose a short option that is either below support for a put spread or above resistance for a call spread.  The farther away I pick my short strike, the lower the net premium I'll receive. There are two additional, somewhat related, ways to evaluate a short strike. I can use the value of the delta of the short strike price to make a selection. One of the characteristics of delta is that it is the approximate probability of expiring in the money by a penny or more. There are more accurate calculations for this and some online brokers provide tools to obtain the probability.

As an example on the thinkorswim platform, one of the columns that can be selected in viewing the option chain is 'probability of expiring'. This value is the probability of expiring in the money by one penny or more. By implication then I can figure the probability of my trade being successful (i.e. expiring OTM) by subtracting this value from 100%.

Vertical Spread: Selecting the Short Strike
As this example shows, the delta and the probability of expiring aren't exactly equal but both can give a good relative indication. With a probability of expiring at 29.22%, that would mean I have a 70.78% chance that this option will expire worthless, which is the goal. I prefer to select a 60-70% probability of success, which means I'm looking for a short strike to have a probability of expiring of between 30 and 40%. Ideally, this strike will also be either below support in the case of selling a put vertical or above resistance in the case of selling a call vertical.

For the long option, I will usually chose the next strike away (farther OTM). For options with $1 increments in the strike price, I often go two strikes wide, making it a $2 spread. My favorite are usually $2 and $5 spreads.

In summary, my selection criteria for a short vertical spread include:
  1. Ample open interest of both strike prices
  2. 20-40 days remaining until expiration
  3. Strike price above resistance (calls) or below support (puts) AND probability of success between 60 and 70% (probability of expiring between 30 and 40%)
  4. Long strike usually one strike price away but no less than $2 wide spread

Analyzing risk/reward

The nice thing about a short vertical spread is that my absolute risk and reward are pretty well defined. The maximum I can ever make is the credit I receive when I sell the vertical spread. The most I can lose is the difference between the two strike prices (minus the inital credit).

Short Vertical Spread P&L Graph

Since the maximum loss is defined, my broker will hold the amount of my maximum loss as margin until I either close the trade or the position expires.

Using the above example, the most I can make on this trade is $.65 while the most I can lose is $1.85 ($2.50 - $.65). My reward/risk is $.65/$1.85 or .35:1. This doesn't seem like a good risk/reward, however let's look at it another way.

If I could potentially lose $1.85 if the trade goes completely bad, that is essentially my investment in the trade. I potentially could gain $.65 if the trade goes as planned so my projected return would be a 35% return on investment. That's not too bad.

That's all there is to it... or is there?

Continue to Short Vertical Spreads - page 2



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