A Basic Introduction to Vertical Spreads – Stop Losing Money When You Predict the Correct Direction

by DropItShock

Vertical Spread Basics

Spreads often get a bad rap for sounding more complex than they end up being. I’d wager quite a few people here don’t even know what the “Select” button is for at the top right of the options screen on Robinhood. I see over and over people losing their money with puts or calls when a vertical spread would have accomplished the same thing but better. To keep this basic I will stick to vertical spreads (both credit and debit) and a bit about Iron Condors, and once that’s done I’ll go into a bit of detail about when and where I use them.

A vertical option spread is purchasing two options; one you’re buying and one you’re selling. You’re literally trading based on the difference between the two option prices. For example, if I bought a SPY 300c 6/3 and sold a SPY 305c 6/3, I would have a SPY 6/3 305/300 Call Debit Spread. What do we accomplish by both buying and selling the right to 100 shares of SPY though? The short answer: This defines our risk. This can seem kind of difficult to comprehend, but it’s fairly simple: The value of the spread can never be more than the difference between the two strike prices.

For the above mentioned trade, we can currently purchase a SPY 6/3 305/300 Call Debit Spread for $0.65 per share ($0.65*100=$65), meaning that the difference in price between the 305c and the 300c is $0.65. If SPY finishes above $305 on 6/3, our 300c we bought finishes in the money as does the 305c we sold, which means the spread between the two option prices has reached its maximum of $5.00. We can now purchase 100 shares of SPY at $300 then sell them to the holder of the option we sold for $305, netting $5 per share for a neat $500. This means that we can make up to $500-$65 = $435 on the trade, a tidy 769% profit.

If you take anything away from this write up, please take this:

An easy way to view a SPY 6/3 305/300 Call Debit Spread is then that you’re betting $65 to win $500 as long as SPY ends above $305 on 6/3.

If you’re not starting to see why vertical spreads are more intuitive than single calls or puts then I encourage you to look back over the paragraph above. The Greeks still matter a lot, but the trade can easily be distilled to the above sentence which is not the case with a single option. I continually see people buying calls and puts, correctly predicting the direction of the market, and still losing money due to IV deterioration or the price not moving enough in the right direction. Vertical spreads simplify the trade by making it only as complicated as you want it to be. If you simply want to bet that a stock will go up over the next month, just set the strikes up to straddle the current price, for example, a SPY 290/280 Call Debit spread. Similarly if you wanted to be against the market, you would do the same thing but by buying a 290 put and selling a 280 put making a SPY 290/280 Put Spread.

A credit spread is very similar to a debit spread but inverted. To create a SPY 6/3 300/305 Call Credit spread, we would sell a 300c and buy a 305c, and because we’re selling the more valuable contract (the lower the strike price the more valuable the call), we get a net credit instead of a net debit, meaning we receive money in our account rather than pay it. That means just like when we short a stock, to close the position we need to pay money rather than receive it. With a call credit spread, we’re now betting against the market: If SPY stays below $300 on 6/3, the credit we received when we sold spread stays ours forever since both the 300c we sold and the 305c we bought expired worthless. You’re still betting on the spread between the two option prices, but now you’re betting on the differences between the two going to 0 rather than the maximum. Now, if the position moves against us and SPY finishes above $305 on 6/3, our SPY 300c we sold will exercise and we will pay for those 100 shares with our 100 shares we receive from our 305c, meaning that we pay at maximum $500. NOTE: Robinhood will hold the maximum you can lose as collateral just in case your trade goes poorly, so if you receive a credit of $65 on the trade, you’ll effectively have another $435 locked up until you close the trade.

Until now I have assumed that the underlying stock price will always finish outside of the range of your spread which has made things a little cleaner. In reality, if you should choose to hold until expiration and the underlying price is between the two strikes, one of your options will exercise and the other will expire worthless. For example, if on 6/3 SPY ended at $303, for our SPY 6/3 305/300 Debit Spread our 300c would exercise and we would have 100 shares of SPY purchased at $300, netting us $3 per share. Considering that most people in this sub could not handle a purchase of 100 shares of SPY at $300, Robinhood will exercise your spread an hour before close at market prices (which is why I will always sell before this point since you can do a lot better than market prices most of the time).

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Basics Summary

Thus ends the basic portion of the write up. The benefits of vertical spreads are:

  • Defined risk just like calls and puts
  • Much simpler to conceptualize profitable scenarios
  • Requires less capital than calls and puts in cases where share prices are high (TSLA and AMZN). This is due to the fact that you’re playing the difference between option prices and not the ability to sell 100 shares of the underlying.

Options Profit Calculator is a very useful resource for learning not only vertical spreads but any options and I highly recommend playing around with it if you’re new to options: www.optionsprofitcalculator.com/

Details and Tips

  • Liquidity: Spreads are inherently less liquid than single options since it’s twice as many transactions (even if it doesn’t seem like it since you’re paying for it all at once). You’ll find that until single options, it is more difficult to get prices that are in the midpoint of the bid-ask spread, meaning you’ll have to pay more for debit spreads and get less credit in credit spreads when opening the positions and vice versa when closing the position. What this means is that it is important to trade options that have high volume, and as a result, low bid-ask spreads. I’ve been burned in the past by purchasing PLNT spreads and losing $100 when purchasing and selling, so I stick to highly traded securities such as SPY, DIS, AAPL, BA, etc. I also always trade on $5 increments when I can help it, since $5 increments are nearly always more liquid than any other strike.
  • Risk and Reward: There are a lot of knobs to play with if you want more or less risky spreads. Clearly the further OTM your spread is the less you’re paying for that spread and the higher the reward is, which also goes for ITM being more costly as less reward. Wider spreads between the two strikes gives you a larger zone of “medium” rewards whereas tighter spreads create a more all-or-nothing reward structure. I don’t have too much more to say here, if you want to know more about this, play with Options Profit Calculator linked above.
  • Impact of Implied Volatility: One of the chief benefits of vertical spreads is that we’re avoiding the largest effects of changes in IV since it hits both the leg that we are long as well as the leg we are short. IV still impacts spreads though, since increases in IV cause spreads to increase due to larger expected moves, and contractions in IV cause decreases in IV for opposite reasons. All this means is that we want to use Debit Spreads when we expect IV to increase and Credit Spreads when we expect it to decrease.
  • Theta: You’ll hear a lot about people saying that theta works for you in a credit spread and against you in a debit spread. This is technically true, since as theta causes option values to tick down, spreads tighten by nature. In reality though, theta only really hurts your debit spreads when they are OTM. Believe me, you’ll still be feeling the theta burn if your credit spread is OTM as you watch your 5/15 SPY 300/305 Put Credit Spread become less and less likely to be ITM. It’s one of the reasons why Iron Condors are set up with two credit spreads, one capping the range and one creating a floor: You want theta to be working for you in both cases (since both are ITM).
  • Uneven Payouts: I couldn’t find a better term to use for this, but you’ll find that especially for underlyings that have significant upward expectations, you’ll get “more value” out of betting on a downward move. For example, for a SPY 290/280 Call Debit Spread, you’ll pay $6.24 even though SPY nearly right in the middle after closing at $284.97. If there was no expectation of upward movement we would find that a $10 strike debit spread perfectly centered on the current price would cost $5.00, but that is not the case. This spread functions as an interesting indicator of current market sentiment, but it functions more as a lagging indicator than a leading one, which means that betting on upward moves is much more cost effective after a large drop (such as if you’d made bullish bets during the drop over the past few days).
  • Entering a Position: I’ve found that two things hurt me when I’m entering a position: Giving up too much value when picking a bid, and being too patient in filling my bid. Robinhood is pretty shit at showing you the actual bid-ask spread for a vertical spread, so I like to start bidding at slightly lower than the midpoint of the bid-ask and slowly canceling and reordering the position, upping the purchasing point each time I do. This way I don’t accidentally lose $20 of value by accepting a worse ask than I needed to while also not giving my position time to move while I’m not in it yet. Spreads are surprisingly frustrating to enter when you’re inexperienced, and I’ve certainly given up a thousand or two in fucked up entrances over the past few months. My advice would be to not skimp on planning your entrance.
  • When to Close Position: I dislike holding my winning plays until expiration for multiple reasons. When the underlying finishes between the strikes of your spread, you end up exposed to pin risk as you can’t sell out of your long/short position until the market opens. I personally also don’t like having the risk that a sudden change in the underlying can cause a winning position to suddenly shift into a losing one, so I usually don’t look for more than 95% gains on a single position and exit out once that has been achieved.
  • Iron Condors: The only strategy I’ll talk about other than vertical spreads in this writeup since they’re also fairly basic in execution. Iron Condors involve two credit spreads: A call credit spread which forms a cap and a put credit spread which forms a floor. With an Iron Condor you’re betting that the underlying will expire between the two spreads. For example, I currently hold a 6/19 275-300 Iron Condor that consists of a 270/275 Put Credit Spread and a 300/305 Call Credit Spread. While the idea here is basic, realistically you’re not holding an Iron Condor to expiration every time, so it’s important to experiment with how the value of an Iron Condor valuation changes as it matures. Taking a look at a theta decay curve will show you where you should expect most of the value to come from. The another big Greek to consider for an Iron Condor is Delta. The delta of an Iron Condor is determined by simply adding the delta of each position within the Iron Condor (short positions are negative delta). Since the expectation for SPY is that the underlying will go up over time, a zero delta Iron Condor (hedged against price movements at time of purchase) will be significantly lower than the midpoint between the two spreads of the IC. I personally like a bit of negative delta in this environment since you end up making money when the underlying decreases and IV increases due to delta, and you also make money when the underlying increases and IV decreases. One last thing to consider when opening and closing an Iron Condor is that it is purchasing two spreads at once, which means that it requires even more liquidity than spreads do to trade profitably. Since you have to buy these so close to the ask and sell so close to the bid, Iron Condors work much better as trades to hold over a period of at least a week. This isn’t to say I haven’t bought and sold an Iron Condor over a one day stretch, but its certainly not optimal.
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Alright this got a bit long, and there’s more to talk about, but I’ll stop here. DISCLAIMER: Now that you’ve read this post, I’ll admit I’ve only been actively trading for about three months. I just finished a Finance undergrad and I’ve been investing unsuccessfully for five years until this point where I’m finally up about 100% from when I started over something silly like 100 trades. I’m not gonna post all of my past positions, but my current positions can be found here. Suffice to say that I made a ton off bearish spreads and it was a rude reeducation that made me learn it was necessary to play both sides of the market.

TL;DR: Spreads are easier to conceptualize, don’t worry as much about IV and theta, have defined risk, and require less capital than puts/calls. An easy way to view a SPY 6/3 305/300 Call Debit Spread is then that you’re betting $65 to win $500 as long as SPY ends above $305 on 6/3.

 

 

Disclaimer: This information is only for educational purposes. Do not make any investment decisions based on the information in this article. Do you own due diligence.