The Basics of Vertical Option Spreads

03/17/2011 1:01 am EST

Focus: OPTIONS

Josip Causic

Instructor, Online Trading Academy

An options expert profiles the net debit spread, or vertical option spread, which results when a trader simultaneously buys an option with a higher premium and sells an option with a lower premium.

By Josip Causic

A bear put spread and a bull call spread are sister strategies because they are both debit verticals. They are also known as net debit spreads, which result when a trader simultaneously buys an option with a higher premium and sells an option with a lower premium. The investor is said to be a "net buyer" and expects the premiums of the two options (the options spread) to widen.

The main difference between the two vertical debit strategies is market outlook. Their respective adjectives ("bear" in the bear put and "bull" in the bull call) reflect the direction of the strategy.

Again, for simplicity's sake, I will refer to the long vertical put spread as a bear put, even though it does have many different names, depending on the broker. Some call it a vertical debit put, others call it a vertical put buy.nevertheless, experienced option traders should not get bogged down in the name, for it is the intricacies of the strategy that matter.

A bear put spread is a strategy that can be used when market conditions are, (1) somewhat neutral to bearish, and (2) the implied volatility of the underlying is low or in its lower range. Buying a vertical debit spread is much more suitable for the environment that we are currently in. When it comes to a bearish outlook, the trader does have a choice to purchase the long put if he or she feels a strong bearish bias; however, if the bias is slightly less bearish, or as I mentioned above, is neutral to bearish, then putting on a vertical debit put (a bear put) gives you a slight discount when compared to the long put.

The basics of a bear put involve first buying a put and then selling a put with a lower strike on the same underlying and in the same month of expiry. The strategy always produces a debit to our account because the higher-strike put always costs more than the lower-strike put. The maximum profit potential is achieved if the stock or the underlying trends down below the lower-strike put.

Let us look at a specific theoretical example. For instance, if an issue is trading around 49 and the trader forecasts that it will drop and stay below 49 by expiry, then a long option could be purchased (at the Ask) at a strike price that is higher than the current stock price, for example, at 50. Then the trader could short (at the Bid) the put, which is one strike price lower than the current stock price, for instance, at 47.50. The visual depiction in the chart below illustrates my point.

chart
Click to Enlarge

To determine the net debit, the sold premium must be subtracted from the premium paid for the long put, so 2.50 - 1.00 = 1.50. The net debit is also the maximum loss that could be taken in the trade if the trade is held until the expiry. The maximum profit, on the other hand, is calculated by subtracting the net debit from the width of spread. In our example, 2.50 is the spread width (50 put - 47.50 put). So maximum profit, or Max P = 1.00 (2.50 - 1.50).

Unlike the credit spread, the money immediately departs from the trader's account at the moment the spread gets filled. The goal of the bear put is to have both options become in the money (ITM) by expiry. In other words, we should be aiming to get the highest premium possible in the shortest possible time. The maximum profit might not be attainable, so if we are able to take off the spread earlier and keep the majority of the maximum profit, then we have done well as an option spread trader.

However, if the stock goes up, then the closing of the spread needs to be performed. The spread could still be mildly profitable or just break even, depending on how fast we acted. Exiting early prevents suffering the maximum loss, which could be substantial. For novice option traders, it is difficult to exit a losing trade early due to the belief that right after they exit, the stock might do exactly what they had anticipated. When the underlying goes against you, even though exiting does not provide a profit, it does minimize the loss.

How to Approach Option Expiration

Brokerage firms do send out reminders in the week prior to expiry to those who are holding options that are about to stop trading on the third Friday. If the trader chooses to hold on to the vertical debit put until the last minute, then it is certain that he or she will receive an e-mail from the broker. At no point should the trader assume that if both options are in the money, that they won't be assigned on their short ITM put.

If the trade is held until the last day and the options are about to expire ITM, then we need to act. The short leg being ITM at expiry could generate assignment, for the initial put sale gives the trader that obligation if the buyer chooses to exercise their put. In our case, the opening trade was buy to open (BTO) + 50 put @ 2.50 and sell to open (STO) - 47.50 put @ 1.00. If it hasn't been done as of that last day, now we must reverse these to close the spread: sell to close (STC) - 50 put and buy to close (BTC) + 47.50 put.

I hope this helps you understand vertical spreads so you can implement these strategies in your own trading account.

By Josip Causic, instructor, Online Trading Academy

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