Cut Risk Using Vertical Option Spreads

11/23/2011 11:10 am EST

Focus: OPTIONS

Carolyn Boroden

Commodity Trading Advisor and Technical Analyst, Synchronicity Market Timing

Carolyn Boroden believes the vertical option spread is a go-to strategy for limiting risk, and especially in volatile markets, the limited profit potential is a worthwhile tradeoff.

Option traders can get very sophisticated with the strategies they use, but it doesn’t have to be that way.  One strategy that you can use is a vertical spread, and our guest today is Carolyn Boroden to talk about how she uses them.

So Carolyn, you’ve recently switched to using options instead of the underlying itself to trade. Talk about why you like vertical spreads.

Well there are some times where the price of the outright puts or calls is rather high, and personally, I don’t want to risk that much on the trade, so the way that you can create a lower-risk set-up is by doing a vertical spread. 

So for example, you might buy the closer put and then sell the further put, and that will basically tighten up your risk. You won’t be risking nearly as much if you do that. 

You do also limit the profits. If you just did a put or a call by itself, you have unlimited potential, but if you don’t like the risk, you should look at some vertical spreads.

And do you recommend or like doing this in times of volatility because it limits your risk?

Yes, absolutely, and especially in some of the high-flying stocks.

Give us an example of one of the stocks or ETFs you’ve used a vertical spread on recently.

Apple (AAPL) is one of them. Now that’s been one that seems to be bulletproof, but every time you get a nice healthy correction, I like to go in and look at that one because if we do have higher targets, then I would expect the move to resolve itself to the upside. 

So for example, there was a recent set-up where I bought a 390/395 call spread. 

How did that work out?

It worked out nicely. I didn’t stay for the whole run because I wasn’t willing to take something over the weekend, but I did get some money out of it.

How long are you typically in the trade?

That one I believe was only two or three trading days.

And that’s pretty typical?

Yes.

How about time decay? Do you worry about that, or do you try to have options that you’re going to have some time for the trade to work out, or is two or three days not enough time to even worry about that?

Yeah, I typically try and find something that has anywhere from 15 to 30 days left in it. 

The only time that I would use an option that was going to expire soon is if they’re relatively low priced and I expect the move to occur within the next day or so with that particular signal. 

Then it’s worth using them, but otherwise, for some of the longer-term views where I might want to keep something longer, I try and go out further.

Now a lot of traders get into the "Greeks," the Gammas and Deltas, etc. Do you concern yourself with that too much?

Not too much. I actually am a new student in this area, so I’m learning a bit about the Deltas and the time value and all that, but I don’t’ get too involved in it. I just stick with the basics. What my price projections are and as far as what my targets are. 

See related: Know Your Option “Greeks”

I will take a peak at the implied volatility because I know that’s something I should definitely look at, but otherwise, not too much.

Why the switch? Why did you switch to options?

Well, I started a new update on stocks and ETFs and I noticed that my stock set-ups were really working out very well. I had another partner in the business that was using options and thinkorswim, so what I did was download the package, tested it with fake money, and then I just funded the account. It just been a great tool. 

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