Option strategies that limit your risk: Buy a Vertical Spread

A spread offers the trader the opportunity to limit losses on an option position in exchange for a limited gain potential. It involves the simultaneous purchase and sale of option contracts of the same class (puts or calls), on the same underlying security. The expiration month and/or strike price will be different. When a vertical spread is bought, the investor pays a higher premium for the option purchased than he receives for the premium of the option sold.

Example:

Buy 1 ABC May 80 Call @ 9
Sell 1 ABC May 90 Call @ 5

This spread is executed for a net cost of $400 (9 point premium paid � 5 point premium received). As shown in the graph below, the trader will profit if the market price goes above $84. The trader will maximize his profit at $90. The entire $400 will be lost if ABC declines to $80 or below at expiration.



The mechanics are exactly the same if a put spread is purchased as opposed to a call spread except the profit and loss regions are on opposite sides of the breakeven point as shown here:

Example:

Sell 1 ABC May 80 Put @ 5
Buy 1 ABC May 90 Put @ 9

This spread is also executed for a net cost of $400 (9 point premium paid � 5 point premium received). As shown in the graph below, the trader will profit if the market price falls below $86. The trader will maximize his profit at $80. The entire $400 will be lost if ABC stays above $90 at expiration.



Buying a Vertical Spread has several advantages and disadvantages in relation to buying a naked option. Among the advantages are:

1. Requires less capital to enter a trade (since you are taking in some premium for the option you sell).
   
2. Closer break-even point
   

The primary disadvantage to this strategy is that profit potential is limited. The primary reason for using this strategy is to take advantage of disparities between different options. You should buy a vertical spread ONLY if the option sold is trading at a significantly higher volatility than the option you buy.


When To Exit Vertical Spreads

Exiting at a Loss
Determine before entering trade if you will hold a losing trade until expiration or cut your loss early. If you are planning to cut losses, determine the maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then you should consider exiting the entire position.

Exiting at a Profit
Maximum Profit (MP):

Calls:
a = (strike price of option sold -strike price of option bought)
b = (price of option bought -price of option sold)
Maximum Profit (MP) = (a -b )

Puts:
a = (strike price of option bought -strike. price of option sold)
b = (price of option bought -price of option sold)
Maximum Profit (MP) = (a -b)
Trade Period (TP) = Time until expiration.

Exit Rules:

1. During first half of TP, exit trade if 80% of MP is obtained.
   
2. During second half of TP, exit trade if 90% of MP is obtained.
   
3. Exit trade if price of option sold declines to .125 (stocks) or is worth less than $100 (futures).
   
4. If there are two weeks until expiration and you have a profit, you may consider placing a break-even stop to prevent an adverse price movement from turning a small profit into a large loss.