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Tactics Vertical Spreads
What are Verticals Vertical spreads are typically defined as twolegged option strategies with different strike prices but the same expiration date.
Vertical Spread Types Credit Spreads Bear Call Bull Put Debit Spreads Bull Call Bear Put
Primary Use Directional trading primarily used for capturing price movement Can use Vega or Theta for advantage Verticals have controlled risks and defined max profits
OTM Credit Spreads Uses the same expiration for all options Net credit for the trade Typically sell OTM option Protect with cheaper option further OTM Theta is an advantage Short Vega Rising IV typically hurts this position Drop in IV may allow an early exit Look for High IV relative to the Forecast Volatility Clear direction is an advantage Can win even if stock moves a against us some
Bear Call Scenario Scenario Stock XYZ has had a gap down on bad news and we expect it to fall further This news has exposed significant weakness in the stock It is currently trading at $52.53 The following month options set to expire in 38 days IV is high because of the news (~51%) Historically this stock has never had a measured historical volatility greater than 42%
Bear Call Trade Sell an Out of the Money Call (60 Strike @.60) I chose a Delta of.19 Far enough away to be safe from a minor retracement Close enough to capture decent profit This is your judgment call Protect by buying further OTM Call (65 strike @.28) Tighter strikes lower risk, but also have a lower return In general tighter is better, until commissions take up too high a % of the credit Total credit =>.60 -.28 =.32 Factor in commissions also Margin for this trade equals the risk Max loss = $5 (difference between strikes) Max Loss is offset by the credit you get ($.32) Margin => 5.00 0.32 = $4.68 Return on Margin =.32/4.68 = 6.8%
Bear Call Analysis What is my Max Risk? The difference in the strikes used minus the credit received This is normally the margin requirement for trade Am I getting enough credit to take the risk of the trade going against me? Max loss is often much larger than the profit of the trade % chance of winning is normally high Compare IV to Historical Volatility High IV relative to Historical Volatility is a good sign for this trade (1.2 or higher is a good ratio) Higher Historical Volatility means higher probability this goes against me.
Time Credit Spread- Tips Shorter duration trades make faster returns Higher % per day return Longer duration trades give you wider strikes and less susceptible to quick market moves Choose duration based on market risk Volatility Look for IV Higher than the forecast volatility IV should be near the high end of its normal range Careful of outrageous IV often a signal of a big move that may be in a direction you don t expect Avoid major events (i.e. earnings, FDA announcements, etc ) Trends are your friend Exit & Management Risk only a reasonable amount of your portfolio Focus on the time value of the trade, what % are you making per day Close the trade early when possible, use the margin for new trade (80% of max profit is my typical target)
Bear Calls - Specifics Remember that IV tends to increase on quick drops in stock price. This effect can reduce the profit on a Bear Call while you are holding the position. If the stock price goes up, IV will have a tendency to drop. This can protect you a little from the trade going against you and give you more time to effectively manage the trade. As expiration approaches, a high IV won t matter as long as the stock closes below the strike of our short call.
Bull Put Scenario Scenario Stock XYZ has been trending up on good performance Expectations are solid It is currently trading at $32.48 No big events or risky announcements The following month options set to expire in 38 days IV is in upper 1/3 of its range excluding earnings announcements (35%) Historical volatility is near 24%
Bull Put Trade Sell an Out of the Money Put (30 Strike @.52) I chose a Delta of.22 Far enough away to be safe from a minor retracement Close enough to capture decent profit Closer to stock price = Higher Risk + Higher Reward Protect by buying further OTM Call (29 strike @.35) Tighter strikes lower risk and lower margin, but also have a lower return Watch the % of your profits commissions consume Total credit =>.52 -.35 =.17 Factor in commissions also Margin for this trade equals the risk Max loss = $1 (difference between strikes) Max Loss is offset by the credit you get ($.17) Margin => 1.00 0.17 = $0.83 Return on Margin =.17/.83 = 20.4% (better trade)
Similar considerations as Bear Call What is my Max Risk? Bull Put Analysis The difference in the strikes used minus the credit received This is normally the margin requirement for trade Am I getting enough credit to take the risk of the trade going against me? Max loss is often much larger than the profit of the trade % chance of winning is normally high Compare IV to Historical Volatility High IV relative to Historical Volatility is a good sign for this trade (1.2 or higher is a good ratio) Higher Historical Volatility means higher probability this goes against me.
Bull Put - Specifics Remember that IV tends to decrease on rising stock prices. This effect can increase the rate at which you can capture the profit on a Bull Put Spread. IV will increase if the stock goes down and the trade goes against you. This will cause you to lose money faster than expected if the trade goes bad. As expiration approaches, a high IV wont matter as long as the stock closes above the strike of our short call.
OTM Credit Spread Review Credit Spreads are good ways to capture directional price movement Overpriced Implied Volatility is an advantage. IV higher than the forecast volatility gives us an edge in credit Spreads. We use both the expected directional price movement and time decay to our advantage. Capture a portion of the max profit quickly and reuse the margin Credit Spreads make money if the stock moves in the expected direction or does not move significantly against you with a high probability of success. Most often the max risk of these trades is higher than the max gain but the high probability of success overcomes this deficiency.
Alternative Spreads ITM Debit Spreads Duplicate OTM Credit Spreads Risk of Assignment No Advantage OTM Debit Spreads Low Probability of success but high leverage Limited Risk Great Hedge Trades (Low cost, but big payout on large move) ITM Credit Spreads Duplicates OTM Debit Spread Risk of Assignment