The Most Overlooked Option Strategy

06/02/2011 6:00 am EST

Focus: OPTIONS

Option traders who ignore the basic vertical spread strategy may be leaving profits on the table, as it can be used to produce strong returns with defined risk in a variety of different market conditions.

There is an option strategy that I used recently that I want to discuss here because it is often overlooked by many traders. In addition to writing covered calls and cash-secured naked puts (same risk profile, by the way), one of the most basic spread constructions available to option traders is the vertical spread.

A vertical spread can be written when an option trader believes prices are going up (bull call spread) or when prices are going down (bear put spread). In addition to the previous trades, which are placed as debit trades, option traders also have the ability to place vertical credit spreads. While vertical spreads regardless of nature are a very basic option trading strategy, they can produce strong returns with defined risk.

A brief description of a vertical debit spread involves buying a call or put and simultaneously selling a strike further away from the money. Vertical debit spreads always have a directional bias depending on whether calls or puts or used. The sale of the call or put that is further away from the money results in a credit and helps reduce the total cost of the spread, thereby reducing the capital risk.

A call debit spread, also called a bull call spread, is used when a trader expects higher prices. A put debit spread, also called a bear put spread, is utilized when the option trader expects lower prices.

A vertical credit spread is established in the opposite construction of a vertical debit spread. The construction involves selling a call or put that is closer to the money and buying a strike that is further away from the money. This strategy profits from time decay as well as price action. The maximum gain is limited to the difference in the credit received for the contract that is sold and the debited premium that is required to purchase the long strike.

Vertical credit spreads always result in a trader receiving a credit. A call credit spread, also known as a bear call spread, is used when an option trader is expecting lower prices. A put credit spread, also known as a bull put spread, is utilized when an option trader expects higher prices.

I typically use vertical debit spreads when I want to place a trade that has defined risk and when I am expecting an underlying’s price action to move in a specific direction. However, vertical credit spreads are often overlooked by many traders, and this is most certainly a mistake.

My favorite time to utilize a vertical credit spread is when price action across the equity indices is ugly. In fact, a nasty selloff where implied volatility is juiced in most equities presents an outstanding opportunity to construct vertical credit spreads.

With the commodity complex getting hammered recently while the US dollar increased in value, a lot of the agriculture-based companies have suffered. The Market Vectors Agribusiness ETF (MOO), as an example, has lost close to 10% from recent highs.

NEXT: Using Vertical Spreads to Profit from This Action

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I was stalking MOO and looking for a bottom in the price action, and on May 23, I looked on as MOO was close to testing its 200-period moving average as shown below:

chart
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I had also been stalking Deere & Company (DE) for a while and looking for a bottom. As it turns out, DE is the single largest individual holding held in the MOO ETF. When I saw MOO bounce near its 200-period moving average and at the same time looked on as DE closed in on its 200-period moving average, I felt that we were near a short- to intermediate-term bottom in the agriculture space.

I immediately looked at the DE option chain, as well as the historical implied volatility chart. The trade offered solid risk definition as the 200-period moving average was my support level, and credit spreads offer an option trader precise capital risk attributes.

Since Deere & Company had been under significant selling pressure, implied volatility was elevated, which would also put the wind at my back.

When writing credit spreads, implied volatility is critical and must be monitored. I knew I was selling juiced option premium, as the implied volatility was historically elevated. The closest at-the-money strike on the put side was the June DE 80 put contract. I proceeded to sell the June DE 80 put contracts and bought the June DE 77.50 put contracts in a 1:1 ratio to set up the spread.

The maximum risk per put credit spread was $197. The maximum gain was $53 per spread. At expiration, the maximum yield would be earned if DE closed at $80/share or more. The maximum yield of the trade would be 27% (53/197) based on maximum risk. The profitability curve of the DE put credit spread is shown below:

chart
Click to Enlarge

I had absolutely no intention of holding this trade to expiration. In fact, my trading plan was to close the trade as soon as a 15% return based on max risk was reached. I employed a hard stop based on the underlying Deere & Company stock price of $80.90 per share.

Essentially, the trade had a 1:1 risk/reward ratio (also referred to by traders as a 1R trade). I entered the trade, and at the time of writing, I still had the trade open, but with the higher prices I was seeing on Friday morning (May 27) in DE, I will be closing my trade with a gain near 15% of my maximum risk and 100% of my hard-stop-based risk.

Often times, option traders overlook basic trading strategies like a vertical credit spread. In a stock market correction, or in a situation where a particular underlying has been under selling pressure for quite some time, implied volatility is juiced, and a major support/resistance level is nearby, vertical credit spreads offer solid risk/reward.

Furthermore, option traders fail to use basic strategies like vertical spreads, which provide them the opportunity to trade around bounces, topping patterns, and bottoming patterns without the total capital risk associated with buying and/or shorting stock.

By JW Jones of OptionsTradingSignals.com

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