Many investors and traders venturing into the world of options begin with single-leg options strategies. These basic strategies—buying and selling calls and puts—can help new options traders understand the mechanics of options trading, as well as the objectives of such strategies:
- Risk managementLeverageThe potential to generate income
Basic strategies can also help new options traders understand the risks. But the next major milestone (or wakeup call, for some) is the moment they realize that long single options may not always be the most capital-efficient method to pursue.
Enter … vertical spreads. Now, don’t let the name intimidate you; this risk-defined options strategy is just one step up (well, actually a “leg up,” to be technical) from the beloved entry-level long call or put. This type of entry-level spread, if you will, is simply the sale of an option combined with the purchase of an option. But why do such a thing?
It’s All About the Risk and Reward
Most options traders understand that a good strategy offers favorable odds, and favorable odds typically begin with an assessment of the risks of a particular trade against the potential reward. Depending on the target price you’ve set on a stock you’re trading, a vertical spread might allow you to be more capital efficient as you pursue your trading objectives.
First, the basics. A long vertical call spread is simply the purchase of a call option on a stock and the sale of a higher-strike call with the same expiration. So, for example, if a stock is trading at $185, you could buy the $190 strike call and sell the $195 strike call as a spread.
A long vertical put spread would involve buying a put and selling a lower-strike put with the same expiration, so if a stock is trading at $185, you could buy the $180 strike put and sell the $175 strike put as a spread.
Recall that buying a call or a call vertical spread has a bullish bias, meaning it tends to increase in value as the underlying stock rises. Conversely, buying a put or put vertical spread has a bearish bias, meaning it tends to increase in value as the underlying stock falls. It’s worth noting that when buying options, you’re always racing the clock. At expiration, an out-of-the-money option will expire worthless, meaning you lose the entire premium paid.
Since your risk with both the single-leg strategy and the long vertical spread strategy is limited to premium paid, plus transaction costs, the vertical spread may represent a more cost-effective way to pursue your trading objectives. The premium you collect from your short strike can help offset some of the premium paid for your long strike. The difference, as we will see, is that you limit your potential upside with the spread. Plus, transaction costs are higher with spreads than with single-leg options.
Here’s an Example of a Typical Options Chain
So let’s compare. Figure 1 shows an example of a typical options chain. The underlying stock is trading at $186.44, and the options expiring in June 2018 have 30 days until expiration. Suppose you have set a short-term price target of $195 for the stock. Would you rather buy the $190 call at its fair value of $2.43, or the $190-195 call spread at $1.43 (assuming you buy the $190 call at the offered price and sell the $195 call at the bid price)?
Remember the multiplier! It’s important to note that the multiplier for listed U.S. equity options is 100, because each standard equity option contract represents 100 shares of the underlying. So, in dollar terms, the total premium for the $190 call is $243, and for the call spread it would be $143, plus transaction costs.
FIGURE 1: EXAMPLE OPTION CHAIN. The $190 call is offered at $2.43. The bid for the $195 call is $1. Buy the $190 call or the $190-195 call vertical spread?. Source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
The images below show the expiration payout graphs for the two choices. Note that if the underlying stock is trading at your target price of $195 on the day the options expire, had you bought the $190 call, your payoff would be $195 minus the strike of $190, minus the $2.43 premium paid, times 100 = $257, minus transaction costs. However, with the call spread, your payoff would be $195 minus the strike of $190, minus the $1.43 premium paid, times 100 = $357, minus transaction costs.
FIGURE 2: OUTRIGHT CALL VS. CALL SPREAD. The spread shows a lower initial cost, and a higher payoff at the target price, but the upside potential is limited to the short strike. Source: The thinkorswim platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.
Here’s the Analysis
Of course, with the call spread, an expiration date price of $195 in the underlying stock would be the point at which you would receive the maximum payoff potential, but had you instead just purchased the $190 call outright, your upside potential would continue if the underlying stock rose higher than $195. For example, if the stock finished at $197 at expiration, had you bought the $190 call, your payoff would be $197 minus the strike of $190, minus the $2.43 premium paid, times 100 shares = $457, minus transaction costs.
But again, as an options trader, would you have ridden this trade all the way to $197, or would you have looked for an exit point along the way? Remember, we began this example by supposing you had a target price in the stock of $195. So if $195 was indeed your target, and thus your exit point, the vertical spread would have allowed you to catch the entire move to $195, but at a lower entry cost.
And if the stock stayed at $186.44, or went down? In each case, you would have lost your entire premium, plus transaction costs. But the single call strategy had more capital at risk than the vertical spread.
This is the exercise many options traders go through when assessing potential strategies. Remember, it’s all about the risk and reward.
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