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In Asia Pacific Optionetics’ Discussion Board, there was recently some discussion about vertical spreads. One of our Asia Pacific traders made the following comment:

“As we all know [Emphasis is mine] selling options has more risk than buying options. e.g. selling vertical spreads. Do you know where the risks are? If you are wrong, you can lose more and very QUICKLY.”

In a related topic, one of our students in the Singapore Interactive Technical Trading [ITT] Class came to me and said she had some problems settng a stop on a put vertical credit spread.

It would appear that there is still some confusion amongst our Asian Pacific students on vertical spreads. Hence, let me devote this short article to address the two particular issues noted above. I’ll try to keep it short, especially because when this article is posted, I will be on hospitalization leave. Guess that I am coming to the stage of my life when I need to watch my health closely, just like my portfolio.

Is selling a vertical spread risky?

I think until now, a fair amount of students are still confused with the debit/credit vertical spread on one hand, and the premium outlay/ premium collection strategies on the other. Let me say this one more time: a credit spread need not be absolutely a premium collection strategy, and, by the same token, a debit spread need not be absolutely a premium outlay strategy. I guess this is the main root of the confusion.

Let’s look at a simple example. My friend Alec is bullish on stock XYZ, which is currently trading at $50. He uses Optionetics Platinum to check the implied volatility [IV] of XYZ front month’s options. He is concerned with the so-called ‘not-so-low’ IV and therefore decided to do a vertical spread. He believes that XYZ should have approximately a 67% chance to move either up or down by a strike. Hence, he has chosen a bullish vertical spread.

In his thought process, he first looks at XYZ Mar 50-55 Call spread and this spread will cost him $1.50. He knows that if XYZ moves to $55 at March expiration, his maximum reward should be $3.50. Why?  This is because a 5-point vertical spread can only be worth $5. Since Alec pays $1.50 for this spread, his maximum reward shall be $3.50 ($5 - $1.50). Is this simple math? I think so and I hope so. But before he places the order, he also checks out the value of XYZ Mar 50-55 Put spread. If the call spread costs him $1.50, he knows the Put spread should be trading at $3.50. Now, after this process, he learns that the put spread is actually worth $3.40, and thus, Alec sticks to the Mar 50-55 Call spread and pays $1.50 for that.

Suppose the Put spread is worth $3.60. Instead of buying Mar 50-55 call spread, Alec should sell Mar 50-55 Put spread because there is one-dime advantage. Imagine that saving a dime on this trade will increase the potential return on investment by 6.67% [$0.1/$1.50 x 100%]. Would you not agree that selling a put spread in this case is better than buying a call spread? 

Please stop here for a moment. Since XYZ is currently trading at $50, the 50 call will be an at-the-money [ATM] option and does not have any intrinsic value at all. Likewise, the 55 call is an out-of-the-money [OTM] option and does not have any intrinsic value. Without going into details, we should know that if XYZ does nothing, no matter Alec has paid for it, it consists entirely of extrinsic value, and will suffer from time decay. If this is true, would you then not agree that this call spread (i.e. Mar 50-55 Call spread) is a premium outlay strategy because Alec needs XYZ to move up to generate the required intrinsic value? Had Alec chosen Mar 50-55 Put spread, the same greeks profile will apply. Alec would still need XYZ to move up to generate the intrinsic value. That being said, can we now agree that whether the trade is a long Call spread or a short Put spread, it is still a premium outlay strategy? Does it matter if this is a Call Debit spread or a Put Credit spread?

Let’s change the example and assume that Alec decides to sell a Mar 45-50 Put spread (which is a bullish trade, as we know). He works out that he can sell the put spread for $1.50. Again, before placing the order, he already has an idea that the Mar 45-50 Call spread should be worth $3.50. Let’s assume that Alec needs to pay $3.60 for this Call spread, and he will be better off by selling Mar 45-50 Put spread for $1.50 and save a dime. Since the 50 Put is ATM, it has only extrinsic value. If XYZ can stay above $50, the extrinsic value will decay and it is to Alec’s advantage. So, do you agree that this is actually a premium collection strategy?  Imagine that if for some reason the Call spread can be bought for $3.40 in this example, it will still be a premium collection strategy. Hence, whether this trade is a long call spread or a short put spread, it is still a premium collection strategy. Does it matter if this is a Call Debit spread or a Put Credit spread?

In a nutshell, I don’t see what this student sees in his statement in that one type of vertical spread is riskier than another, assuming they have the same month and same strikes. I hope this will clear up some of the confusion associated with vertical debit and credit spreads.

How do you set a stop for a vertical spread?

One trader in our ITT Class looked for a decent volume spike set-up. She said that she sold a Mar 100-110 Put spread for a credit of $1.90 on stock DEF. She is worried about how to work out the stop for this trade if it goes in the opposite direction.

I think a lot of us who received a conventional education have no problem saying “buy low, sell high.” But when it comes to “sell high, buy low,” some of us may scratch our heads. Let me offer you a tip here.

Is selling a Mar 100-110 Put spread the same as buying a Mar 100-110 call spread, at least in synthetic terms? If you say “yes,” would you agree that this trader could be said to have bought this synthetic Call spread for $8.10? Now, suppose she is willing to lose $2.00 on this trade. It means that she will have to sell the synthetic Call spread when it is only worth $6.10.

Now, let’s look at this closely. If she has to sell the Call spread when it is worth $6.10 to close the position, would it not be true to say that in her actual trade, she is looking to buy back the Put spread when it is worth $3.90?  Pause for a moment and decide if this makes sense to you. I know that some of you may be struggling here. With a pen and paper, walk through the above example. After a few attempts, I am sure that you will be able to figure it out. In my opinion, this thought process will help a fair amount of beginners who have difficulty working out stops in a credit spread. In this case at least, this student thanked me for walking her through the math and she understood my thought process.


Jack Wong 
Staff Writer
Optionetics.com ~ Your Options Education Site

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