A Beginner’s Guide to Vertical Spreads RESTRICTED

A Beginner’s Guide to Vertical Spreads

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A Beginner’s Guide to Vertical Spreads RESTRICTED

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A Beginner’s Guide to Vertical Spreads RESTRICTED

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A Beginner’s Guide to Vertical Spreads RESTRICTED

A Beginner’s Guide to Vertical Spread

Let’s kick off the New Year with an absolute game changer in your Options Trading.

Some of you by now have become really good at Options Trading using Vertical Spreads. But if you’re still struggling to nail Vertical Spread strategy, or if you’re just getting started in this world, this comprehensive article is most definitely for you.

I’ve put a lot into this article for you, so make sure to read completely and ask questions to get everything you need to start the new year off successfully!

What is Vertical Spread?

In this Vertical Spread focused article, you are going to learn: 1. What is a Vertical Spread? 2. Two ways you can structure a Vertical ? 3. 3 Different scenarios (Up, down and sideways) and how to calculate your risk/reward. 4. Is Vertical better or Vertical ?

Vertical Spread

Vertical spread is an spread strategy whereby an option trader purchases a certain number of options and simultaneously sells an equal number of options of the same class, same underlying security, same date, but at a different .

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A Beginner’s Guide to Vertical Spreads RESTRICTED

In Vertical Spread, when one option is making money, the other option is losing money and thus Vertical spreads limit the risk involved but at the same time they reduce the profit potential.

Vertical Spreads can be either Debit Spread or Credit Spread, and can be created with either all calls or all puts. Vertical Spreads can be bullish or bearish.

Bull Vertical Spreads

Bull vertical spread is an options trading strategy designed to profit from a rise in prices of the underlying asset we’re trading. It can be constructed in two ways:

- By using put options – “Bull Put Spread”, a Vertical Credit Spread - By using call options – “Bull Call Spread”, a Vertical Debit Spread

When structured for similar strike prices, similar expiration, both Bull Put Spread and Bear Call Spread have similar risk/reward profile.

Here is the Proof of above using Apple Inc. (AAPL) Vertical Spread real-time prices.

Help: How to read above Option Table: • It is $5 wide vertical spread (the difference between two strikes). • Look at “Mark” column. That is the “mid price” between bid and ask.

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• Call Options are on the left and Put Options are on the right. • If 100/105 Bull Call Vertical Spread Costs $2.16 to open, it’s maxim profit is $5- $2.16 = $2.84, almost the same as the credit by selling 105/100 Bull Put Spread at $2.87!

One may choose either of the two of vertical spreads to trade his directional view. However, it is much better to structure a trade based on: a) Bid/ask b) Ease of fill

Based on my experience, it is a good idea to structure a Vertical Spread using “out of the money” options for better fills.

Using a hypothetical example let’s review Bullish Vertical Spread first, along with possible outcomes (profit and loss). We will use a hypothetical example on a stock which is currently trading at $48 per share.

Let’s assume:

1. Based on some technical or fundamental analysis, we are bullish on this stock and we expect the price to rise in the next 15 days. 2. Let’s suppose today is January 15th and we decided to go through with our bullish strategy based on our bullish signal. 3. Expiration date of both our options is Jan 31st. 4. Stock is currently trading at $48.00 per share.

Bullish Vertical Spread Using Call Options

Here is the price chart marked with entries for selecting spread using Call Options:

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Structuring the Bull Call Spread

• First, we will buy one with a strike price at $50.00, which is trading for $0.50 (for example) per share. Since options come in lots of 100 shares, we would spend $50 for this particular Call option. • Simultaneously, we will sell one Call option with a higher strike price at $52.50. By selling this call for $0.20 per share (for example), we would receive $20 (100 shares X $0.20). • By setting up two options in this manner, we have constructed (or purchased) a Bull Call Spread and it cost us $30. We paid $50 for the lower strike price Call Option (price at $50.00), while we received $20 by selling the higher strike price Call Option ($52.50). • Since it was a debit i.e. cash outflow to open this spread, it is called a Debit Spread. In this case our Initial Debit is $0.30 per spread (or $0.30 X 100 = $30).

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Here is the same chart marked with profit/loss areas according to potential price movement by expiration date:

The price at $50.30 represents our breakeven point, and any price move above that value would result in profit.

- If the price stays or closes below our first strike point at $50.00, our loss would always be the same since it is determined (and capped) solely by our initial investment of the spread we purchased. Buying our first call at $50.00 strike price for $50 while selling our second call at 52.50 strike price for $20, our overall cost will be $30 ($50 - $20). We say our Debit Spread cost us $30. Debit amount in bull call spread is the maximum loss amount. - If the price stays above $50.00 strike price, but below $50.30 value, our first long call option is starting to make some money (go in the money) and it will offset our loss caused by our initial investment, finally breaking even at $50.30.

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- Price moving above $50.30 will increase our profit up to a point when it reaches $52.50, where our short call is placed. That short call option is “capping” our profit, and any price movement above $52.50 will not result in any additional gains. It is the point where our short call option starts to work against us. - As the upper short call is losing money, our lower long call is making money – options are “hedged” against each other. Maximum profit is locked in when price is at or above short call $52.50 strike point - by expiration.

Here is the visual representation of the risk/reward profile at expiration to explain what we just described above:

Notice the X-Axis i.e. the stock price axis to see how price movement affects our profit/loss.

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A Beginner’s Guide to Vertical Spreads RESTRICTED

As our purchased call option ($50.00 strike price) is getting “in the money”, our loss is being reduced. Once the price moves above the $50.30 value, we start profiting. That profit increases up to a price of $52.50, where our short option is placed. Notice how a further increase in price (for example it can move to $60 per share) doesn’t affect our maximum profit which is capped at $220.

Vice versa, notice what would a potential decrease in stock price to $0 mean for our vertical spread – you’re correct – it doesn’t affect our loss amount.

Geek’s Notes: Detailed calculations of the Risk/reward are explained below: Scenario 1: Stock is equal to or above $52.50, let’s say at $57.00 In this case, we will make maximum gains. The profit will be calculated based on intrinsic values of each option at expiration.

1) Intrinsic Value of sold Call Option (Stock Price- Strike price), Is = $57.00 - $52.50 = $4.50

2) Intrinsic Value of purchased Call Option (Stock Price- Strike price), Ip = $57.00 - $50.00 = $7.00

Profit/Loss = Ip –Is – Initial Debit = $7.00 - $4.50 - $0.30 = $2.20

Since each option controls 100 shares, our gains will be $2.20*100 = $220. That’s +733% gains ($220 / $30 = 733%)

Scenario 2: Stock is equal or below $50.00, let’s say at $49.00

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In this case, we will make maximum loss. The loss, just like profit, will be calculated based on intrinsic values of each option at expiration.

1) Intrinsic Value of sold Call Option (Stock Price- Strike price) = $49.00 - $52.50 = $0 (since it can’t have negative value) 2) Intrinsic Value of purchased Call Option (Stock Price- Strike price) = $49.00 - $50.00 = $0 (since it can’t have negative value)

Profit/Loss = Ip – Is – Initial Debit = $0 - $0 - $0.30 = –$0.30

Since each option controls 100 shares, our loss will be $0.30*100 = $30. Remember, this value actually represents our initial investment and thus 100% loss.

Scenario 3: Stock is above $50.00 but below $52.50, let’s say at $51.00 In this case, profit or loss will again be calculated based on intrinsic values of each option at expiration.

1) Intrinsic Value of sold Call Option (Stock Price- Strike price), Is = $51.00 - $52.50 = $0 (since it can’t have negative value)

2) Intrinsic Value of purchased Call Option (Stock Price- Strike price), Ip = $51.00 - $50.00 = $1.00

Profit/Loss = Ip – Is – Initial Debit = $1.00 - $0 - $0.30 = $0.70

Since each option controls 100 shares, our gains will be $0.70*100 = $70. That’s +233% gains ($70 / $30 = 233%)

Bullish Vertical Spread Using Put Options

First, we will sell with a higher strike price at $52.50, and simultaneously, we will buy equal amount of Put option with a lower strike price at $50.00. Let’s assume that

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these two transactions, when combined, gave us $2.20 credit - since options come in lots of 100, our credit received for this bull put spread is $220.

We are not allowed to consider this amount as our profit (yet) since it is only initial credit we received for constructing our spread in this manner. Assuming underlying price is in our favor, our profit will accumulate gradually and only materialize on expiration.

Why sell higher strike and buy lower strike in case of bull put spread?

It is because we are comparing the risk/reward profile with respect to Bull Call Spread and we are using the same strikes.

By setting up two options in this manner, we have constructed (or sold) a Bull Put Spread and we collected $220 credit. Since it gave us credit to open this spread, it is called a

Credit Spread. In this case our Initial Credit (Ic) is $2.20 (or $2.20 * 100 = $220)

Here is the same chart marked with profit/loss areas according to potential price movement by expiration date:

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Next, let us show what happens with our profit/loss when a stock price moves in different directions as we are nearing our expiration date.

- As soon as price reaches $50.00, our long put option starts to lose money, but simultaneously, our short put option (at strike price of $52.50) is producing profit for us – as stock price moves higher. - Price at $50.30 represents our break even point, after which our profit from this setup starts increasing. It will increase up to a point when price reaches $52.50 – after this point, since both our positions are hedged against each other, the maximum profit will not change. It is capped at $220, the initial credit.

Here is the visual representation of the risk/reward profile at expiration to explain what we just described above:

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Geek’s Notes: Detailed calculations of the Risk/reward are explained below: Scenario 1: Stock is equal to or above $52.50, let’s say at $57.00 In this case, we’ll make maximum gains. The profit will be calculated based on intrinsic values of each option at expiration.

1) Intrinsic Value of sold Put Option (Strike Price- Stock price), Is = $52.50 - $57.00 = $0 (since it can’t have negative value)

2) Intrinsic Value of purchased Put Option (Strike Price- Stock price), Ip = $50.00 - $57.00 = $0 (since it can’t have negative value)

Profit/ Loss = Initial Credit +Ip – Is = $2.20 + $0 - $0 = $2.20

Since each option controls 100 shares, our gains will be $2.20*100 = $220. That’s +733% gains ($220/$30 = 733%). We get to keep all the credit we collected to open this trade.

Scenario 2: Stock is equal or below $50.00, let’s say at $49.00 In this case, we’ll make maximum loss. The loss, just like profit, will be calculated based on intrinsic values of each option at expiration.

1) Intrinsic Value of sold Put Option (Strike Price- Stock price) = $52.5 - $49.00 = $3.50 2) Intrinsic Value of purchased Put Option (Strike Price- Stock price) = $50.00 - $49.00 = $1.00

Profit/ Loss = Initial Credit +Ip – Is = $2.20 + $1.00 - $3.50 = –$0.30 Since each option controls 100 shares, our loss will be $0.30*100 = $30.

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Scenario 3: Stock is above $50.00 but below $52.50, let’s say at $51.00In this case, profits or loss will again be calculated based on intrinsic values of each option at expiration.

1) Intrinsic Value of sold Put Option (Strike Price- Stock price), Is = $52.50 - $51.00 = $1.50

2) Intrinsic Value of purchased Put Option (Strike Price- Stock price), Ip = $50.00 - $51.00 = $0 (since it can’t have negative value)

Profit/ Loss = Initial Credit + Ip – Is = $2.20 + $0.0- $1.50 = $0.70 Since each option controls 100 shares, our gains will be $0.70*100 = $70. That’s +233% gains ($70/$30= 233%)

As you may notice, in both cases, the profit/loss (risk/reward) was same whether you chose Bull Put Spread or Bull Call Spread using the same strikes.

However, as mentioned earlier, it is much better to structure a trade based on bid/ask slippage and ease of fill, and thus it will be much better to use Bull Call Vertical Spread vs Bull Put Spread. Out of the Money Calls will be much easier to be filled vs Deep In the Money Puts and bid/ask slippage will also be relatively smaller.

This covers only BULLISH VEERTICAL SPREADS using both call options and put options.

In the next e-mail, you will receive book containing chapters on BEARISH VERTICAL SPREADS so you can follow through completely.

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Be Patient with Yourself

Finally, I have to remind you to be patient with yourself. This isn’t all going to fall into place tomorrow. My goal is to give you a roadmap and a bunch of examples, so you see where you want to go with your options trading and have the skills to get there day by day.

How do you like it? What additional thoughts or questions do you have? Send those to [email protected] - I will answer every question, no strings attached so you can make the most of your learning.

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