Strategy

Vertical Spread

Type of Strategy

trading / investing

sentiment

varied

implied volatility

generally high

description

Vertical spreads are two-option combinations of either calls or puts with different strike prices and the same expiration.

Set-Up

(X<Y)

Long (Bull/Debit) Call Spread: Purchase a call at X and sell a call at Y. 

Short (Bear/Credit) Call Spread: Sell a call at X and purchase a call at Y. 

Long (Bear/Debit) Put Spread: Sell a put at X and purchase a put at Y. 

Short (Bull/Credit) Put Spread: Purchase a put at X and sell a put at Y.

Soi perspective

Vertical spreads are an integral part of many option strategies, with the flexibility to provide value in many situations.  Alone, they provide directional exposure to an underlying security.  Vertical spreads can be used to mitigate risk, hedge positions, replace stock holdings, establish price constraints, and offer stock price exposure within a defined risk framework.

Beyond utility as standalone strategies, vertical spreads are often used in combination with other options or option spreads to provide a desired risk/return profile in a specific market environment.

As standalone strategies, vertical spreads provide a defined risk/return profile upon transaction entry.  When compared to a naked short option, the vertical spread provides a reduced capital requirement due to defined risk.

SOI recommends that regardless of defined risk nature, vertical spreads should be managed based upon full notional value of the spread as if exercised in an account.

 

guidelines

1) Credit (short) vertical spreads are generally preferred over debit (long) vertical spreads, though every short spread has an equivalent long spread.

  I.E.:  Stock XYZ at $50

A) Short 50 put + Long 45 put sells for $1.7 {BE=50-1.7=$48.3}

B) Long 45 call + Short 50 call costs $3.3   {BE=45+3.3=$48.3}

  – In both cases, the Break-Even point is $48.3 with identical profiles

  – Preference for A due to common put/call skew and higher liquidity

  – Preference for A as less likely to require option exercise

2) Traders selling vertical spreads target a credit of 1/3 the spread width

3) Option investors may also employ specific Scaffolding Spreads

 

management

Traders generally enter vertical spread transactions with approximately 45 DTE.  Profit targets of 50% of the credit received should be taken if available prior to reaching 21 DTE.  If 50% profit has not been achieved at 21 DTE, the trader should consider either closing the transaction or rolling the transaction out in time, if the rollout can be done for a credit.

 

images from www.theoptionsguide.com

example – paypal (pypl) short put spread

Investor/trader is bullish on Paypal Holdings Inc. (PYPL), currently trading at $240.00 per share.  Investor is willing to purchase shares below a price of $225/sh. but wishes to limit capital employed prior to any purchase.  Trader wishes to define risk at the $220.00 level.  Implied volatility is at 40%.

1) In an offensive account (tax-free), one 45-DTE, 30 delta put is sold at the $225.00 strike for $7.20

2) In an offensive account (tax-free), one 45-DTE, 25 delta put is purchased at the $220.00 strike for $5.70

3) Net credit received = $1.50  ($1.5 / $5 = 30% strike width)

Consideration: Investor should manage position at notional exposure of $22.5k

 

Vertical Spread: PYPL Short Put Vertical

Management – PYPL Example

Trader may set a GTC, BTC order for $0.75 (50% max profit = 50% net credit)

Trader at ~20 DTE if profit target of $0.75 has not been reached:

– Consider rolling out the spread in time if this can be done for a net credit

– Consider closing out the trade for less that 50% profit

– If neither option amenable, especially if the spread is near maximum loss, the trader may simply let the spread continue, as incremental downside risk is minimal

Investor will collect premium if PYPL closes above $225 at expiry

If PYPL closes within $220 – $225, investor will be long shares at market price

If PYPL closes below $220, investor will be debited for $5.00 ($3.50 net) and has the option to buy shares in the market.  If shares are purchased, net cost will be market price +$3.50 (<$223.50), a price below the target purchase of $225/sh