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.
   

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.