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Understanding the Short Vertical Spread Option Strategy - Part I

June 08, 2012 | Comments: 0 | Views: 187

Do you trade the US market? As I continue talking to many novice traders about my experience in trading the US market, some of them told me that they were still shy away from learning how to trade this market. Why? In Singapore and Malaysia, the stock price of blue chip companies is generally low and affordable but this does not appear to be the case in the US. Nevertheless, my argument is that Singapore and Malaysia do not have any options markets while the US has the world largest options market. I believe there is a value proposition for you and me to look at how to trade the US market by using options as a trading instrument.

There are different kinds of options strategies. For this purpose, I will categorise them into two main groups - directional strategies and non-directional strategies. In this article, I will discuss a non-directional trading strategy - a short vertical spread.

I still believe most options traders are directional traders although I may be wrong. They look at the stock chart to determine where the stock is likely going and buy calls or puts accordingly. Here is the problem. Directional traders make money only when the value of the options they bought goes up and there are three pre-requisites for this to happen. They have to right in (i) the stock direction; (ii) the timing; and (iii) the implied volatility prognosis. Due to these three elements, it may seem a daunting task for directional traders to evaluate any directional trading opportunities.

For those who prefer less work, they may consider using non-directional strategies. What do I mean by that? If we are bullish on a stock, we can sell a put vertical spread instead of buying a call. To construct this spread, we will sell a put at a higher strike and buy another put at a lower strike using the same expiration month. The premium we collect from the sell leg is more than the premium we pay for the buy leg. As a result, we will receive a net credit and this is why this spread is also known as a credit spread. Having said that, we must understand that there is no free lunch here. A credit spread is not a risk-free trade. Let me illustrate this with the following example.

XYZ (a hypothetical company) is currently trading at $150 per share. Tom (a hypothetical trader) has constructed a vertical put spread by selling 140 put and buying 135 put using the same expiration month. Let's say the net credit received by Tom is $100 per option contract. Here is how the risk and reward of this trade are determined:

  • Maximum reward is $100 as this is the net credit received by Tom.
  • Maximum risk is $400 as this is represented by the difference between the strikes ($5) x 100 minus the net credit received ($100).

As you can see, this trade does have risk. If Tom is dead wrong, his maximum exposure will be $400 per option contract.

Another key feature of this strategy is that the sum of the maximum reward and maximum risk is always equal to the difference between the strikes multiplied by 100. If the net credit received by Tom is $200, his maximum risk will be $300. If the net credit received by Tom is $50, his maximum risk will be $450.

How does Tom make money from this trade? In the best case, Tom will be able to keep the credit if both legs expire out of the money at expiration. This is when XYZ stays above $140 at expiration. Given that XYZ is currently trading at $150, Tom will be able to make money if the stock goes up or moves sideways. Even if XYZ were to go down a little bit, Tom will still make money provided the stock stays above $140 at expiration.

While this may look attractive to you, the real challenge is the trade management. As you can see in the above example, the maximum risk of this strategy is higher than the net credit received due to the fact that it has a higher theoretical probability of making money. We cannot afford to hit the maximum risk (in our example, $400). This is because even if we were to make $100 each for the next 4 trades, we will only break even after completing 5 trades in total.

I hope this part gives you a good overview of a short put vertical spread for bullish trading opportunities. In Part II, I will discuss how a trader can use a short vertical spread for bearish trading opportunities.

About the Author

After working in the corporate world for 16 years as an international tax lawyer, Jack Wong is now an entrepreneur working from home, allowing him to spend more time with his family. He specialises in coaching his clients to identify their passion in life, and how to make money from home. For more details, check out Jack's Website and Personal Blog.

Source: EzineArticles
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