First on the disclaimer, Vertical Spread Options is a relative intermediate options strategy so please understand the mechanics and exercise it with care.
A vertical spread is sometimes called a credit spread – which involves simultaneously buying and selling of options of the same underlying at the same expiration date with a different strike price. The goal of a vertical spread is to optimise return through maximising profits while limiting downside risk.
This optimisation of returns is achieved through a combination of mechanism which the way options premium and time expiry works – i.e time decay works in favor of options seller (against option buyers) and implied volatility moves with the bullish/bearish direction of the market.
A vertical spread strategy reduces these challenges facing options player.
Let’s understand this in more detail.
Challenge 1:
Time decay results as a decrease in option’s time value
Time decay results as a consequence of decrease in an option’s time value.
When you sell a put or call option, you are betting against the time value that the underlying stock will reach its strike price on a given time period. Since the life of an option is limited, the time value of an option decreases with each passing day as expiration looms . In return, you are rewarded with a premium which you can collect once it passes the expiration.
If you are interested to learn more about this basic strategy, you can view my past article here.
Since a vertical spread strategy involves simultaneously buying one long and one short option, the combined position reduces the effects of time decay as you have essentially foot on both sides.
Challenge 2:
Implied Volatility Risk
Implied Volatility (IV) is a metric used in an option to calculate the future moves of an underlying stock.
It corresponds to the risk factor as a perception of a big movement in the share price of an underlying stock both to either the upside or downside.
IV usually increases when market is generally bearish and decreases when market is generally bullish. It is usually most volatile during and post-earnings result when market swings the most.
Similarly, since a vertical spread strategy involves simultaneously buying one long and one short option, the combined position reduces the fluctuation impact as this strategy has feet on both sides as well.
Types of Vertical Spread
There are two types of the vertical spreads:
- Call Vertical Spread
- Put Vertical Spread
A put vertical spread is a bullish option strategy which involves buying a long and short position in a put options.
When you establish a bullish position using a credit put spread, the premium you pay for the option purchased is lower than the premium you receive from the option sold. As a result, you still generate income when the position is established, but less than you would with an uncovered position.
Let’s take a look at the chart below:
i.) Buy put at strike price A
ii.) Sell put at strike price B
Max Profit: Net premium received
Max Loss: Strike Price B less Strike Price A less net premium received
The sweet spot: You would ideally want the stock to be at or above strike price B at expiration
A Put Vertical Spread is an alternative to the sell put strategy, but with limited risk (and also upside as a trade-off). A naked sell put strategy has a very large loss to stomach in play as the underlying can go down all the way to $0 (technically, it is unlikely to go to zero but a severe down market can push it down hard).
With the vertical spread strategy, you are still getting your premium from selling a put at strike B but limiting your risk with strike A if the stock goes down.
Case Study: Tesla (Nasdaq: TSLA)
Let’s explore this with a real case study on Tesla (Nasdaq: TSLA).
Assume I am bullish on TSLA – with the recent earnings and factory opening up, I think it can continue its longer term uptrend after recent weakness in the market has passed.
Tesla is currently trading at $640 as of writing and I am using the Dec 2022 expiry, which gives us around 180+ days to expiration.
- Sell Put at strike $800, I will receive a premium of $224.8 – which at 100 shares give me a $22,480.
- Buy Put at strike $500, I will have to pay a premium of $210.30 – which at 100 shares I will have to fork out $21,030.
The net premium received less paid will be at $22,480 – $21,030 = $1,450, which I still pocket at the end of the day, regardless what happens.
Scenario 1: Tesla hits $850 (above strike B)
This is a fantastic scenario.
Tesla hits above my strike price at $800 which means my put expire worthless and I get to pocket the entire premium.
My put which I long at $500 also expire worthless since I get to sell in the market higher at $850.
My total profits would be $22,480 – $21,030 = $1,450.
Scenario 2: Tesla hits $150 (below strike A)
This is not a good news because my put at $800 will get “assigned” to me, but thankfully, I have earlier bought a put at strike $500 to offset the downside a little bit.
Hence, my total profit / (loss) would be $50,000 – $80,000 + $1,450 = -$28,550.
It is bad but it is still better than had I not make this vertical strategy in play.
Had I simply just did a sell put strategy, my loss would have been more magnified at $15,000 – $80,000 +$22,480 = -$42,520.
Scenario 3: Tesla stays at $640 at expiry
I will still get my assignment at strike $800 but my long put at strike $500 will expire.
Hence, my my total profit / (loss) would be $64,000 – $80,000 + $1,450 = -$14,550.
Had I simply just did a sell put strategy, my profit would have been larger at $64,000 – $80,000 + $22,480 = $6,480.
Conclusion
I look at this pretty much as a spread to reduce downside risk as a hedge but also reduces your upside if the stock remains stagnant or moves above your strike price.
Another advantage of this strategy is since you are both long and short a position, your margin requirement on this strategy is capped and offset against one another, leaving you more margins on hand.
If you are thinking of owning the company for long term anyway, then it doesn’t matter for as long as you have the money to long on your assignment.
I trade my positions using multiple brokerages such as Tiger, uSMART and moomoo. If you are interested, you can explore them. Each of them has their own distinct advantages which I have written in detail on a separate post.
I have also started using more of my social channels to post ideas and thoughts in recent weeks so if you are interested, you may follow me at my Facebook, Instagram or Twitter profile here.
