Oftentimes traders and investors get stuck where they have a position in the stock, or want to initiate one, but aren’t sure when the move will occur. Vertical options offer a great way to get paid while you wait.
After hours of in-depth analysis you finally decide to take a position in a stock that you’re certain will go higher, once everyone sees what you do. Day by day, you watch it languish. Weeks turn into months. Finally, after a while you give up, only to watch it take off the day after you sell it. Unfortunately, unless the stock pays a nice dividend, the opportunity cost of holding a position that doesn’t move can be just as detrimental as quick losing trades.
However, consider the same investment, but part of the position you take an initiate as a vertical option at the lower end of the range. You sell a put spread (which we’ll discuss later) and roll it each month, collecting some serious coin in between. Vertical spreads allow you to take the place of the institutions and sell options with a more defined and limited risk than naked options. You can define the exact amount you want to risk, and even get your risk reward to 1:1 for every trade.
What Is A Vertical Spread?
Vertical spreads are when you sell an option at one strike price and buy another one at the next strike price or further in line, with either calls or puts. The idea is that the second option in line costs less to purchase than the first one you sold.
Here’s an easy example to follow. Below is a snapshot of the quoted vertical spreads for the SPY ETF:
The current price of the ETF is $280.15. If you look at the strikes, you’ll notice they all come in about 50 cent increments. So, the one we’ll pick for this example is the 280/280.5. This means that one of the strikes is at $280 and one is at $280.50. If you look at the call side, you’ll see the bid/ask at $0.27/$0.33 (or – $0.30). On the put side you’ll see $0.17/$0.23 (-$0.20).
If you thought the SPY was going higher at some point you would sell the put spread. Here’s how the transaction plays out:
In this case you sell the $280.50 put and buy the $280 put simultaneously, receiving $0.20. As long as the SPY closed above $280.30 you’d break even ($280.50 – $0.20). The most you could make, assuming the SPY closes above $280.50, would be $0.20, and the most you could lose is $0.30 ($280.30 breakeven – $280)
Why Would I Use A Vertical Spread
Unlike naked options, which involve unlimited risk on the call side, and cash covered puts, which require you to hold cash in reserve, vertical options only require the total amount of potential losses to be set aside. This unique feature allows it to be used in some of the more basic margin accounts, including some retirement accounts.
What’s exceptionally interesting is when you sell these spreads at the halfway point between the strikes you get a 1:1 risk to reward. That means that as long as you’re correct >50% of the time, you will make money. When you have a stock that’s bouncing around in a range that you’re waiting to take off, this can be extremely useful as a way to trade the range, while still maintaining your overall investment.
While the concepts may seem difficult at first, they’re actually rather easy to execute once you understand the basics. They’re a bit more advanced than basic options strategies. However, vertical options can provide you a way to make money off a position you already own or plan to enter while it’s trading within a range.