Option strategies that limit your risk: Sell a Vertical Spread

The Sell a Vertical Spread strategy offers traders a number of advantages. First and foremost, it allows traders to take advantage of time decay by selling out-of- the-money options. It also allows them to take advantage of disparities in volatilities between different options. This strategy also allows option sellers to enter a trade with limited risk, rather than exposing themselves to the unlimited risk associated with selling naked options. Finally, it allows a trader to profit from a market timing forecast if Relative Volatility is extremely high. Remember that most traders generate a market timing forecast and then buy a call or put to try to profit from that market movement without regard to whether volatility is high or low. If volatility is extremely high, the probability of making money is extremely low for the option buyer. So instead, a trader who is bullish on a stock with a high Relative Volatility (6 or higher) might sell a vertical put spread rather than buying a call option.

By selling an out-of-the-money put and buying a further out-of-the-money put he can profit if the underlying stock or futures market goes up, sideways or even down slightly.
The primary disadvantage to selling Vertical Spreads is that profit potential is limited to the difference between the premium received for the option sold and the premium paid for the option bought. In most cases, the profit potential is less than the maximum risk. As a result, traders should only employ the Sell A Vertical Spread strategy if they are confident that they will be able to pull the trigger and cut their loss if the need arises.

An investor creating a call vertical spread will buy the call with the higher strike price and write the call with the lower strike price. The call purchased will have a lower premium that the call written. The result will be a net credit. The trader using this strategy is bearish on the underlying security. A decrease in the underlying stock will cause the call premiums to decrease and the spread to narrow resulting in a profit.


Example:

Buy 10 ABC May 90 Calls @ 5
Sell 10 ABC May 80 Calls @ 9

The spread is executed for a net credit of $4,000. The breakeven point for this trade is 84. If ABC drops below 84, the spread becomes profitable. If ABC is below 80, both options expire worthless and the trader keeps the entire premium sold. If ABC rises above 84, the trade becomes unprofitable with a maximum loss of $6,000 at 90 or more.



A trader creating a put vertical spread will buy the put with the lower strike price and write the put with the higher strike price. The result will be a net credit. An trader using this strategy is bullish. As the underlying stock increases, the put premiums decrease. This causes the spread between the premiums to narrow.

Example:

Buy 10 ABC May 55 Puts @ 1
Sell 10 ABC May 65 Puts @ 8

This spread is executed for a net credit of $7,000 and the trader will benefit if the spread increases. The breakeven point for this trade is 58. If ABC rises above 58, the spread becomes profitable. If ABC is above 65, both options expire worthless and the trader keeps the entire premium sold. If ABC falls below 58, the trade becomes unprofitable with a maximum loss of $3,000 at 55 or less.



When To Exit Short Vertical Spreads

Exiting at a Loss

Determine maximum downside risk and select some percentage of that amount as your stop out point. If that amount is reached or exceeded then exit the entire position. Maximum stop-loss permissible MUST be no greater than maximum profit potential for this trade. For example, say you enter a short vertical spread with a profit potential of $500 and a maximum risk of $1500. You should exit the trade if a loss of $500 is incurred anywhere along the way. Because short vertical spreads generally have greater dollar risk than potential reward, you MUST be prepared to cut losses when necessary.

Exiting at a Profit

Maximum Profit (MP) = (price of option sold � price of option bought)

Trade Period (TP) = Time until expiration.

Exit Rules:

1. During first half of TP, exit trade if 90% of MP is obtained.
   
2. During second half of TP, exit trade if 80% of MP is obtained.
   
3. Exit trade if price of option sold declines to .125 or is worth less than $100.