If You Want Versatility, Go Vertical!

If You Want Versatility, Go Vertical!
By Bill Johnson

Options are powerful, flexible tools for all traders and investors, as they allow risk profiles that cannot be obtained using shares of stock alone. One of the most versatile options strategies is a vertical spread. With this strategy, traders can take a bullish or bearish outlook, but with limited risk.

In the option’s world, any type of “spread” strategy means you’re simultaneously buying and selling options. You’ll be long and short options at the same time.

With a vertical spread, you’ll buy and sell different strikes but with the same expiration. For instance, you could buy a May $50 call and simultaneously sell a May $55 call, which is called the 50/55 vertical spread. It’s called a vertical spread because, if you look at an option’s quote board, the expiration dates run horizontally across the top while the strikes run vertically along the side. With this strategy, you’re “spreading” the strikes vertically.

If you buy the 50/55 vertical, you have the right to buy shares at $50 but the obligation to sell them at $55, which represents a $5 maximum gain. Because lower strike calls must be worth more money than higher strikes, this trade would result in a debit. If you paid $3 for the spread, your maximum profit is the $2 difference. The following chart shows your resulting profit and loss diagram:

Interestingly, you can create the identical profile by using puts. If, instead, you bought the May $50 put and sold the May $55 put, you’ll still have a bullish spread. An easy way to remember is “buy low, sell high” or BLSH, which resembles the word bullish. Any time you buy a low strike option and sell a higher-strike option, whether using calls or puts, you’ll have a bull vertical spread. When using puts, however, the trade results in a credit.

If the 50/55 bull spread costs $3, the 50/55 put spread is theoretically worth $2. In other words, you could sell the spread for $2, which is the maximum gain, and would have a $3 maximum loss. You’ll get exactly the same profit and loss diagram as when using calls. Professional traders will always check the pricing relationships for small discrepancies that may arise. For example, if the 50/55 call spread costs $3, the 50/55 put spread is theoretically worth a $2 credit. However, if the put spread is selling for $2.20, you’re better off selling the put spread. You’ll end up with the same profile, just with a greater maximum gain – and a smaller maximum loss. It pays to understand these differences!

Vertical Bear Spreads

You can also create bearish positions by purchasing puts. Any time you buy a high strike option and sell a lower strike option, whether using calls or puts, you’ll get a bear spread. For instance, you could buy the $55 put and sell the $50 put. Because higher-strike puts must cost more money than lower-strike puts, this trade results in a debit. If you paid $3, the maximum gain is $2, and you’ll get the resulting profit and loss diagram. Of course, you could buy the $55 call and sell the $50 call, which would also result in the same bearish profit and loss diagram:

Why Use Spreads?

While there are many reasons for using vertical spreads, probably the main use is to reduce the cost of the long option. If the $50 call costs $10, for example, perhaps you can sell the $55 call for $7, which reduces your net cost to $3. The tradeoff is that you give up the unlimited upside potential you’d have with buying the $50 call by itself. The benefit is that your maximum loss is reduced from $10 to $3.

Vertical spreads create great risk-reward profiles. In this example, you can earn 66% on your money, but greatly limit the amount you can lose. However, vertical spreads are flexible. If you have the 50/55 vertical call spread and the stock begins to break out, you can buy back the $55 call to close and keep the $50 call free and clear to capture unlimited gains.

Changing Directions

What if you’re in a bull spread, but the stock’s heading down? Verticals are versatile, and you can easily change directions. If you have the 50/55 vertical call spread, you can buy the short call’s corresponding put (the put with the same strike). The long $55 put combined with the short $55 call creates what’s called a synthetic short stock position. Those two options behave exactly like short stock. However, when it’s combined with the long $50 call, the net result is a long $50 put. This is a good example of what professional traders call a “morph,” which is a single trade that allows us the change the profit and loss profile.

Vertical spreads allow traders to buy options that otherwise may have been too expensive. As you get more experienced, you can even use vertical spreads to trade volatility or even volatility skews. Depending on how the spread is constructed, you can make the position bullish, bearish, or even neutral. You can make them premium outlay – or premium collection. The possibilities are endless with options, but the versatility of verticals is hard to match.

Good Investing!

Bill Johnson, Steve Bigalow
and The Candlestick Forum Team

P.S. Bill Johnson’s Alpha Trader Options Course takes you from the very beginning, step-by-step, through an exciting journey into the world of options. At the end, you’ll have the necessary knowledge and confidence to start investing and hedging with options. In addition, you’ll have a rock-solid foundation from which to continue your options education.

Click here for more information about Bill’s Alpha Trader Options course, now with mult-pay options!

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