Lessons from the Pros


Going Vertical

Today we will begin to look at Vertical Spreads. These strategies can be useful on their own in any of three different ways: as a leveraged directional trade (betting on underlying price moving); as a volatility trade (betting on Implied Volatility [IV] to rise or fall); or as an income generator, purely to collect time value. In addition, rather than just being used on their own, vertical spreads can be sub-assemblies in more complex strategies. We’ll start by looking at them on their own.

The term Vertical Spread is a single name for a group of strategies that can be used in all the ways described above. These are the things that all vertical spreads have in common:

  • They are made up of two “legs,” one consisting of long options and one consisting of short options
  • The options are all of the same type (either all Puts or all Calls)
  • The options all share the same Expiration Date
  • Each leg contains the same number of options (10 long calls and 10 short calls, or 3 and 3, etc.)

Examples of vertical spreads would be:

  • Buy a March 150 call and sell a March 155 call
  • Sell a March 150 call and buy a March 155 call
  • Buy a March 150 put and sell a March 155 put
  • Sell a March 150 put and buy a March 155 put

Notice in the above examples that the second position is the exact opposite of the first, and the fourth is the exact opposite of the third. We can choose to be on either side of a spread, depending on our market expectations. As in all option trades, the profit of the trader on one side of the spread is the loss of the trader on the other side of it, and vice versa.

Vertical Spreads as Directional Trades

First, let’s look at using a vertical spread as a directional trade. If we expect the price of something to go up, the most straightforward option position is simply to buy call options on it. Calls go up when the underlying’s price goes up. Simple.

Let’s say that as of the date of this writing, January 31, 2013, we expect the price of GLD, the ETF representing gold, to rise.  Let’s say we think it could rise from its current price of $161.16 to its recent highs of $164 within a month. One way to profit from a rise in the price of GLD would to buy Call options on it.

As of the close on 1/31, the expiration date closest to a month out was the March Weekly options that expire on March 1.  The GLD 160 calls for that date were quoted at $2.80. If GLD were to rise to $164 as of March 1, those calls would be worth $4.00. (the right to buy something for $160 that we could then sell for $164 would be worth $4.00). Subtracting our cost of $2.80, we could make $1.20. This is a profit of (1.20/2.80) = 42.9% in 29 days. This on a move in the underlying of just (164.00 – 161.19) = $2.82, which is 1.75%.

Not bad. But consider this:

We had to be right on the direction, and in a pretty big way. If the price of GLD stayed still at $161.16, the 160 calls would expire with an intrinsic value of just (stock price – strike price) = ($161.16 – $160.00) = $1.16. At our cost of $2.80, we would have a loss of (call cost – call value) = ($2.80 – $1.16) = $1.64 = 59% loss.

Our breakeven price would be (Call strike price + premium paid) = ($160.00 + $2.80) = $162.80. At any price below that at expiration, we would have a loss; at any price above that, a profit. The stock has to move at least to our breakeven point for us not to lose money. In this case it must move up by ($162.80 – $161.16) = $1.64 just to break even. Notice that this is the exact amount of time value in the calls.

Now think about this. If we believe that GLD is likely to go to $164, but not much farther than that in a month, then we are saying that we believe that our possible profit is limited. If we think that, why pay for unlimited profit potential? By selling some of our upside potential, we can make this position much cheaper. That will give us a much better percentage return if we are right.

The 164 calls were quoted on January 31 at $1.00. If we sell one of those as we buy the 160 call, our net cost becomes (premium paid for long option – premium received for short option) = ($2.80 – $1.00) = $1.80.

Note that this would be called a debit spread, because we are paying more money for the long calls ($2.80) than we are receiving for the short calls ($1.00). Someone who does the opposite (for example, whoever is on the other side of our trade) is putting on a credit spread. The person on the debit side is said to be buying the spread. The person on the credit side is said to be selling the spread.

Now if GLD is at $164 at expiration, our long 160 call would once again be worth $4.00. Our short 164 call would be worthless, being exactly ATM (no intrinsic value). So the value of the spread as a whole would be (Value of long options – Value of short options) = ($4.00 – $0.00) = $4.00. Subtracting our cost of $1.80, we would have a profit of $2.20, which is 122% on our $1.80 cost. This is clearly better than the 42.9% we could have made by buying the calls alone as described above.

Notice that this is the best we could do with the spread, no matter how much higher the price of GLD went. We traded away the unlimited profit potential when we sold the 164 calls. Since we own the right to buy at $160 and are obligated to sell at $164, then ($164 – 160) is our maximum profit, period.

Say GLD went to $172 by expiration. Each call would be worth (stock price – strike price). Our long 160 calls would be worth ($172 – $160) = $12.00. Our short 164 calls would be worth ($172 – 164) = $8.00. The difference is ($12 – $8) = $4.

The value of the spread, as always, would be (value of long options – value of short options) = ($12 – $8) = $4.00. The spread’s value is that same $4.00 at any price above the 164 strike price. No matter where the price is, $164 is always more than $160 by exactly $4.00.

In short, the maximum value of a vertical spread is always the difference between the strike prices. The spread can never be worth more than that. It also can never be worth less than zero.

Since buyers want the things they buy to go up in value, the buyer of a spread always wants it to go to its maximum value. This occurs if both options in the spread are in the money at expiration. It follows that the seller of a spread always wants its value to go to zero. This happens if both options are out of the money at expiration.

Since a vertical spread’s profit is limited while a long call’s profit is unlimited, there must be a price level where the calls alone would have paid off better. There is, and it’s easy to calculate. In this case, the spread’s maximum profit would be $2.20, which is 122% on its cost of $1.80. The calls alone would have a higher percentage profit if they paid more than 122% on their cost of $2.80. The call’s value would have to be ($2.80 + 122% of $2.80) = ($2.80 + $3.42) = $6.22. For the calls to be worth $6.22, GLD would have to be above their 160 strike price by that same $6.22.  So at a GLD price of $166.22 or higher at expiration, the calls alone would pay off better. If we think that a price of $166.22 is unlikely, then we are not sacrificing anything by turning the long calls into a spread.

To sum up, compared to a long call position, a debit vertical call spread like this one:

  • Has a maximum value equal to the difference between the strike prices and therefore
  • Has a limit to its maximum profit.
  • Has a lower cost (because the cost of the long call is partly offset by the short call), therefore
  • Has a lower break-even price (stock doesn’t have to move as much to make money), and
  • Has a higher probability of profit (because less movement is needed to profit).
  • Has a higher profit percentage, except in case of very large underlying price moves

As you can see, vertical spreads have a lot going for them. We’ve just scratched the surface, and we’ll explore them more in coming weeks.

For questions or comments on this article, contact me at rallen@tradingacademy.com.

DISCLAIMER This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.

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