How to Trade a Vertical Option Spread

11/09/2009 10:22 am EST

Focus: OPTIONS

In a previous MoneyShow.com article, I introduced the concept of verticals and defined their four main components. Here, I am going to deal with a specific vertical spread that also happens to be one of my favorite strategies. It is known under many different names: Short credit call, bear call, or vertical call sale.

For simplicity and consistency's sake, I will refer to it as a bear call. There are two words in its description: An adjective and a noun. The adjective (bear) modifies the noun (call). A bear call is built by calls, yet the strategy is not a bullish one. The aggregate of the two options' deltas (sold call and bought call) produces a negatively correlated delta.

Whenever the delta is negative, the position's outlook is bearish by nature. A short bear call benefits from time decay, hence, it is wise to sell a bear call when the implied volatility is high or at its higher range. Due to the fact that current implied volatility (IV) is sitting at its 52-week low, or simply at its lower range, I will not present any actual trades.

Placing a Bear Call Trade

When placing the actual bear call trade, it is essential that the trader determines where the price will not be at expiry. If, for instance, the trend is bearish and an underlying is trading below a major area of resistance, then that resistance could be used for strike price selection. For instance, if a fictional, optionable stock is trading at 49.85 and the 50 zone is acting as a significant level of resistance, then selling the front-month 50 call would make perfect sense.

However, prior to the sale of the 50 call, the next higher strike price needs to be purchased, otherwise, the trader would end up with a naked 50 call position. Such a position might require a large maintenance by the brokerage house, or the trade might not even go through if the size of the option trader's account is not big enough. In that case, the trade would simply get rejected.

On the 50-dollar product, the strike prices could be either in dollar increments, or $2.50, or even five dollars. If the strike price increments are five dollars wide, then the trader could first purchase the 55 OTM (out-of-the-money) call, and then proceed with selling the near the money 50 call. The profit and loss graph of the sold 55 call and bought 50 call is represented in Figure 1 below.


Click to Enlarge

When an OTM option is bought, it is worth less than the ATM (at-the-money) option that will later be sold. In other words, the first leg (bought OTM call) will be cheaper than the second leg (sold ATM call). When the math is done, the cost of the bought call subtracted from the premium received for the sold call will produce a credit, hence the name vertical credit call spread.

Whenever the seller of a bear call ends up receiving some money, it is called a net credit spread. Personally, I prefer to be a net premium seller, and in most of my previous articles, I advocated this strategy. Browse the article library to find those articles, which in turn supply the specifics of the actual live trades which I had taken at that time when the IV was in a higher range.

The Goal

The goal of a bear call is to keep as much of the net credit as possible. Again, I am emphasizing the words, "as much as possible." Many times, novice option traders aim at having the maximum profit and not paying any extra commission, yet it could easily happen that the underlying issue could rally on the day of expiry and ruin their perfect plan.

Hence, I suggest keeping greed in check and not aiming at getting the maximum profit, but just a majority of it. By selling an ATM call, the delta is usually 50, which means that the buyer of the call has a 50% chance of winning. If we, as the sellers, were accurate with our technical analysis, and the product moves lower, then the delta changes with the downward move.

In conclusion, the sole purpose of this article was to explain the vertical credit call and emphasize the point that the selling of it should be done when the IV of the underlying is at its 52-week high, or at least in the higher range. At the time of writing this article, the IV of the majority of the underlyings which I am trading are sitting at their lows, therefore, selling credit spreads isn't the most profitable solution right now.

In next week's article, I will focus on the vertical debit call, which should be done when the IV is at its low. Buying a vertical debit spread is much more suitable for the environment that we are currently in. Until then, have green trading and as my (option newsletter) predecessor would say, “Know your options!”

By Josip Causic of Online Trading Academy

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