|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
|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
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:
Let's now take a look at when and how to use this particular strategy.
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 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.
Additional Vertical Spread Links
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.
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.
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%.
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).
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