Lower risk, go vertical

June 25, 2015 01:05 AM

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Options are excellent vehicles for taking a directional view on a market. But buying outright puts or calls are subject to time decay. A straightforward options strategy is the vertical spread. Here’s a profit loss graph of a vertical spread using calls.

You own a call at strike A and have sold a higher strike call at strike B. Generally, the stock or index is at or below strike A and your price target is strike B. Both options have the same expiration date.

A vertical spread can never be worth less than zero or more than the differential between the strikes. Your risk is your net debit and your maximum profit is the difference between the strikes minus the debit paid, with the breakeven point being strike A plus the debit paid.

Here’s a real time example using the bullish dollar ETF (UUP) currently trading at 24.90. You can buy the June 24 call (strike A) at $1 and sell the June 26 call (strike B) at 10¢ for a 90¢ debit, or $90. That $90 is the most you can lose at any level below 24; you make $110 at 26 or above on expiration. Your breakeven is strike plus the debit paid, or 24.90, where it is trading now.

A vertical put spread looks like this:

You have sold a lower strike put (strike A) and you have bought a higher strike put (strike B). Generally, the stock is at or above strike B and your target price is strike A. Once again, you cannot lose more than your net debit paid, and your maximum reward is the difference between the strike prices minus the net debit. And your breakeven point is strike B minus the debit paid.

Here’s a long vertical put spread using the Euro ETF (FXE). 

Your view on the euro is bearish so you buy the June 110 put (strike B) at 1.70 and sell the June 105 put (strike B) at 40¢, a debit of 1.30 or $130 per spread. That $130 is the most you can lose, and the most you can make is the difference between strikes A and B, or $370. Breakeven is strike B minus your debit, or 108.70. 

With both vertical spreads there is no additional margin required beyond the debit paid.
In both spreads, if your view was correct then you want implied volatility to decrease because the near-to-the-money option you sold will decay faster than the now in-the-money option you bought.

If, on the other hand, your view was wrong then you want implied volatility to increase. This is because it will increase the value of the out-of-the-money option you bought faster than it will increase the value of the now, nearly at-the-money option you are short. Also, an increase in implied volatility increases the likelihood of a price swing, putting you back on the path to a profit.

In both spreads it is a good idea to unwind before expiration. This is particularly true of American style stock options with physical delivery. You do not want your inexpensive vertical spread to turn into the underlying value. 

So, we see that a vertical spread is an excellent, easily managed and affordable way to take a directional view on any underlying value. 

About the Author

Randall Liss is a veteran options trader. He helped found the European Options Exchange in Amsterdam (now part of Euronext), was a market-maker for that exchange and is co-founder of The Market-Makers Association. Liss has educated and mentored traders since 2006.