Stock Options: Vertical Spread

Since all markets have the potential to fluctuate beyond their normal trend, it is essential to learn how to use strategies that limit your losses to a manageable amount. There are a variety of options strategies that can be employed to hedge risk and leverage capital. Each strategy has an optimal set of circumstances that trigger its application in a particular market. Vertical spreads are the most basic limited risk strategies and that's why they are often introduced relatively early. These simple hedging strategies enable traders to take advantage of the way options premiums change in relation to movement in the underlying asset.

Vertical spreads combine long and short options with different strike prices and the same expiration date to profit on a directional move in the price of the underlying asset. They offer limited potential profits as well as limited risks. One of the keys to understanding these managed risk spreads comes from grasping the concepts of intrinsic value and time value-variables that provide major contributions to the fluctuating price of an option. In order to understand these important concepts, let's take a closer look at the components that affect option pricing.

Bull Call Spread

A bull call spread is a debit spread created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying asset. However, the total investment is usually far less than that required to purchase the stock. The strategy has both limited profit potential and limited downside risk.

Steps to Using a Bull Call Spread

1. Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move.

2. Check to see if this stock has options.

3. Review call options premiums per expiration dates and strike prices.

4. Investigate implied volatility values to see if the options are overpriced or undervalued.

5. Explore past price trends and liquidity by reviewing price and volume charts over the last year.

6. Choose a lower strike call to buy and a higher strike call to sell with the same expiration date.

7. Calculate the maximum potential profit by multiplying the value per point by the difference in strike prices and subtracting the net debit paid.

8. Calculate the maximum potential risk by figuring out the net debit of the two option premiums.

9. Calculate the breakeven by adding the lower strike price to the net debit.

10. Create a risk profile for the trade to graphically determine the trade's feasibility.

11. Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

12. Contact your broker to buy and sell the chosen call options.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock closes at or below the breakeven point.

To exit the trade, you need to sell the lower strike call and buy the higher strike call or simply let the options expire. The maximum profit occurs when the underlying stock rises above the short call strike price. If and when the short call is exercised by the assigned option holder, you can exercise the long call and deliver those shares to the option holder at the lower long call price, pocketing the difference plus the premium from the short call.

Bull Put Spread

A bull put spread is a credit spread created by purchasing a lower strike put and selling a higher strike put with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying. However, the total investment is usually far less than that required to buy the stock shares. The strategy has both limited profit potential and limited downside risk.

Steps to Using a Bull Put Spread

1. Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move.

2. Check to see if this stock has options.

3. Review put options premiums per expiration dates and strike prices.

4. Investigate implied volatility values to see if the options are overpriced or undervalued.

5. Explore past price trends and liquidity by reviewing price and volume charts over the last year.

6. Choose a lower strike put to buy and a higher strike put to sell with the same expiration date.

7. Calculate the maximum potential profit by computing the net credit of the two option premiums.

8. Calculate the maximum potential risk by multiplying the value per point by the difference in strike prices and subtracting the net credit received.

9. Calculate the breakeven by subtracting the net credit from the higher strike price.

10. Create a risk profile for the trade to graphically determine the trade's feasibility.

11. Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

12. Contact your broker to buy and sell the chosen put options.

13. Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock falls to or below the breakeven point.

14. To exit the trade, you need to sell the lower strike put and buy the higher strike put or simply let the options expire.