Vertical spreads are used for two main reasons: For debit spreads, to reduce the premium amount payable. For credit spreads, to lower the option position's risk. Option premiums can be quite expensive when overall market volatility is elevated, or when a specific stock's implied volatility is high.
Such spreads can thus be easily used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg. As far as credit spreads are concerned, they can greatly reduce the risk of writing options, since option writers take on significant risk to pocket a relatively small amount of option premium. One disastrous trade can wipe out positive results from many successful option trades.
In fact, option writers are occasionally disparagingly referred to as individuals who stoop to collect pennies on the railway track. They happily do so—until a train comes along and runs them over.
Which Vertical Option Spread Should You Use?
Writing naked or uncovered calls is among the riskiest option strategies, since the potential loss if the trade goes awry is theoretically unlimited. Writing puts is comparatively less risky, but an aggressive trader who has written puts on numerous stocks would be stuck with a large number of pricey stocks in a sudden market crash. Credit spreads mitigate this risk, although the cost of this risk mitigation is a lower amount of option premium.
Both call options are in the June expiration cycle. The trade is considered a call vertical spread because the trader is buying and selling call options that are in the same expiration cycle but have different strike prices.
This scenario is typically seen in the latter stages of a bull market, when stocks are nearing a peak and gains are harder to achieve. A bull call spread can also be effective for a stock that has great long-term potential, but has elevated volatility vertical spread options to a recent plunge.
Consider using a bear call spread when volatility is high and when a modest downside is expected.
This scenario is typically seen in the final stages of a bear market or correction when stocks are nearing a trough, but volatility is still elevated because pessimism reigns supreme. Buying stocks at reduced prices is possible because the written put may be exercised to buy the stock at the strike price, but because a credit was received this reduces the cost of buying the shares compared to if the shares were bought at the strike price directly.
Vertical Spreads Explained | The Options & Futures Guide
This strategy is especially appropriate to accumulate high-quality stocks at cheap prices when there is a sudden bout of volatility but the underlying trend is still upward. Consider using a bear put spread when a moderate to significant downside is expected in a stock or index, and volatility is rising. Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid, like to hedge long positions after a strong bull market.
How to Sell Vertical Option Spreads - Thinkorswim Options Basics
Bullish or bearish: Are you positive or negative on the markets? If you are very bullish, you vertical spread options be better off considering stand-alone calls not a spread.
But if you are expecting a modest upside, consider a bull call spread or a bull put spread. Likewise, if you are modestly bearish or want to reduce the cost of hedging your long positions, the bear call spread or bear put spread where you can make money without investing it be the answer.
Volatility view: Do you expect volatility to rise or fall? Rising volatility may favor the vertical spread options buyer, which favors debit spread strategies.
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Declining volatility improves the odds for the option writer, which favors credit spread strategies. If you seek limited made money by fighting for possibly greater risk, this is more in line with the option writer mentality. Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, the best strategy would be a bear put spread.
Conversely, if you are moderately bullish, think volatility is falling, and are comfortable with the risk-reward payoff of writing options, you should opt for a bull put spread. Which Strike Prices to Choose The table above outlined whether the bought option is above or below the strike price of the written option. Which strike prices are used is dependent on the trader's outlook.
There is always a trade-off. Before taking a spread trade, consider what is being given up or gained by choosing different strike prices. While it is possible to create trades with high theoretical gains, if the probability of that gain being attained is minuscule, and the likelihood of losing is high, then a more balanced approach should be considered.
The Bottom Line Knowing which option spread strategy to use in different market conditions can significantly improve your odds of success in options trading.
Look at the current market conditions and consider your own analysis. Determine which of the vertical spreads best suits the situation, if any, then consider which strike prices to use before pulling the trigger on a trade.
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- Vertical Spread: What are Vertical Spread Options? | tastytrade | a real financial network
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- Vertical spreads limit the risk involved in the options trade but at the same time they reduce the profit potential.
- Vertical Spreads Explained (Best Guide w/ Examples) | projectoption
- Vertical Spread Definition
- A vertical spread involves the simultaneous buying and selling of options of the same type puts or calls and expirybut at different strike prices.