Today we'll explore vertical spreads. Basically, a vertical option spread is the purchase of one option and the sale of another with both options having the same expiration month. It is a directional strategy and a vertical spread can be done with either puts or calls, depending on your opinion of where the stock will move. If you're using calls, and you would be if you are bullish, this particular vertical spread is called a "bull call spread." By the same token, if you are bearish, you can use puts to create a vertical "bear put spread."
Why use a spread instead of just buying a call? Good question. Glad I asked it. Using a vertical spread instead of a strait option purchase gives the trader more flexibility. Let's look at some examples from the option chain below.
Apple is trading at $64.02. If you look at a daily chart of AAPL, you'll see that there is resistance at about $70.
If someone was bullish and wanted to buy a call on AAPL, he has a number of choices. Look at the red arrows near the "ask" column.
1) A $60 call would cost $5.90 – with $4.02 of intrinsic value and $1.88 of time value. The delta of the $60 call option is about 74. If you just purchased the $60 call option, your total risk would be the $5.90. That's a lot of money. You can reduce your risk by selling an option at a higher strike price.
Remember, the resistance is near $70. So, there's a reasonable chance that, even if AAPL makes it to $70, it will bounce off resistance and head back down. If you sold the $70 call, you could take in $.95. What have you accomplished? You have just reduced your risk from $5.90 to $4.95.
The price you pay for receiving the $.95 is that you have capped your potential profits. With your $60/$70 vertical spread, the most you can possibly make now is the difference between the strike prices $10) -- if AAPL finishes above $70 at expiration. You would bring in $10 – and your cost for the spread position was $4.95. Your profit would then be $5.05 ($10 less $4.95) – about a 1-1 risk reward ratio.
What is your breakeven on the $60/$70 bull call spread? Since you spent $4.95 for the position, AAPL must, at expiration, be at $64.95 before you will have made any money. It would require a relatively small move of $.93 to reach the breakeven point.
2) Look at the chain again. For this second alternative, let's buy the $65 call – for $2.80. That's less than half of the $60 call in #1 above. So, the risk is less – only $2.80. But, let's create another vertical spread ($65/$70) by selling the $70 call and taking in the $.95. Our new cost basis, and total risk, for this position is only $1.85 ($2.80 less $.95). That's pretty reasonable.
How is this different from #1 above? Calculate the breakeven point. The $65 call is all time value. It has NO intrinsic value and has a delta of only 47. Add your risk of $1.85 to the $65 strike price and you have a break even point of $66.85. That requires a $2.83 move of AAPL stock.
If AAPL would close over $70, the profit would be more appealing than #1. You, the trader, would bring in the $5.00 difference between the two strike prices ($65/$70). Your cost of establishing this trade is only $1.85. Therefore, you would pocket the difference -- $3.15 ($5.00 less $1.85). Not bad. But remember that you are asking more of AAPL stock.
3) Let's take the vertical spread a step further. This example may sound familiar. Not that long ago I heard a seminar company boasting that it has a strategy in which you can be wrong four times, right once, and still make a profit? For a mere $3,000 they will pass along this pearl of wisdom.
Most people think to themselves, "Hey, I can be wrong five times. And the law of averages says I'll be right the sixth time. If I can still make a profit after all that, then I NEED TO KNOW that strategy."
Well, my loyal students, I'll save you the $3,000 – and it's not even Christmas!!
Look at the AAPL option chain again. Let's create another vertical spread. This time let's buy the $70 call (for $1.05) and sell the $75 call (for $.25). Our total out-of-pocket for this five point vertical bull call spread is $.80 ($1.05 less $.25). Our break even point is $70.80 ($70 plus $.80). Our potential profit is the $5.00 difference between the strikes less our $.80 cost – which equals a whopping $4.20. That's one hell-of-a risk reward ratio.
How many times can we be wrong and then be right one time and still be profitable? If we lost $.80 five times, it would cost us $4.00. Then, if we were right the sixth time and made $4.20, that would make up the $4.00 from the previous five tries and leave us a profit of $.20.
Obviously, the further out of the money (away from where the asset it trading) the higher the profit can be. The only catch is that your chances of AAPL moving from $64.02 to $75 in the next five weeks is almost as good as the odds of me losing 30 pounds in the next five weeks. In other words, don't hold your breath. And don't get sucked in to these "pot-of-gold at the end of the rainbow" promotions – if you value your money. Reality sometimes sucks, but it's real and needs to be dealt with as such. There isn't a holy grail when it comes to option trading. There's only understanding strategies and putting as many of the odds in your favor as possible.
4) Do you want good odds? Try this on for size. Look at our option chain again. What if we were to put on a vertical spread that's already ITM (in-the-money)? Let's buy the $60 call for $5.90 and then sell the $62.50 call for $4.10. Our cost for this vertical spread is $1.80. The difference between the $60 and $62.50 strike prices is $2.50. Our potential profit is $.70 ($2.50 less $1.80) – if AAPL closes above $62.50 at expiration.
Think about this. The risk ($1.80) / reward ($.70) ratio isn't as pretty as our previous examples. It's true that we've certainly sacrificed a chunk of profit. But, in return, we now have a much better chance of success. Why? Because, with AAPL trading at $64.02 – well beyond the $62.50 short option. To be profitable, AAPL doesn't have to move up at all. As a matter of fact, it can move up, stay the same and it even has a $1.52 cushion to the downside and the position will remain profitable.
As I've said before, options are simply tools. If you learn how to use them properly, you can increase your odds and put yourself in a position to be profitable.
Missed Any Columns?
Hey, this is good stuff – especially if you're serious about learning options. The Pulitzer people won't likely be knocking at my door soon, but I've taught a lot of people how to conservatively and consistently make money – and they're still making money to this day. I hope you'll become one of them.
So, if you missed any of my previous columns, click on the following link and, hopefully, they will magically appear. http://forexworlduk.blogspot.com
Who Is This Guy? --
Mike Parnos has "been there and done that" – plenty! Known as "Online Trading Academy's Options Therapist," Mike has been trading, consulting and teaching option strategies for over 12 years. Both individually, and through his writings, Mike specializes in teaching conservative and non-directional option strategies while providing therapeutic guidance to thousands of individuals, brokers and institutional traders. Over the years, he has learned from his mistakes, and the mistakes of others, and he's here to share his wisdom with you. "Trading is as much psychological as it is skill," says Mike. "Keep an open mind. You never know what might find its way in there."
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