Risk—it is the focal point around which all trading revolves. It may seem as if profit should be occupying this seat, as most important to trading options, but without risk, there would be no profit! As traders, we must always look for ways to mitigate, eliminate, preempt, and simply avoid as much risk as possible in our pursuit of success without diluting opportunity.Risk must be controlled.
Trading vertical spreads takes us one step further in this quest.The basic strategies discussed in Chapters 4 and 5 have strengths when compared with pure linear trading in the equity markets. But they have weaknesses, too.Consider the covered call, one of the most popular option strategies.A covered call is best used as an augmentation to an investment plan.It can be used to generate income on an investment holding, as an entrance strategy into a stock, or as an exit strategy out of a stock.
But from a trading perspective, one can often find better ways to trade such a forecast.If the forecast on a stock is neutral to moderately bullish, accepting the risk of stock ownership is often unwise. There is always the chance that the stock could collapse. In many cases, this is an unreasonable risk to assume.To some extent, we can make the same case for the long call, short put,naked call, and the like.
In certain scenarios, each of these basic strategies is accompanied with unwanted risks that serve no beneficial purpose to the trader but can potentially cause harm. In many situations, a vertical spread is a better alternative to these basic spreads. Vertical spreads allow a trader to limit potential directional risk, limit theta and vega risk, free up margin, and generally manage capital more efficiently.
Vertical spreads involve buying one option and selling another. Both are on the same underlying and expire the same month, and both are either calls or puts. The difference is in the strike prices of the two options. One is higher than the other, hence the name vertical spread. There are four vertical spreads: bull call spread, bear call spread, bear put spread, and bull put spread.
These four spreads can be sliced and diced into categories a number of ways: call spreads and put spreads, bull spreads and bear spreads, debit spreads and credit spreads. There is overlap among the four verticals in how and when they are used. The end of this chapter will discuss how the spreads are interrelated.Bull Call Spread:A bull call spread is a long call combined with a short call that has a higher strike price.
Both calls are on the same underlying and share the same expiration month. Because the purchased call has a lower strike price, it costs more than the call being sold. Establishing the trade results in a debit to the trader’s account. Because of this debit, it’s called a debit spread.Below is an example of a bull call spread on Apple Inc. (AAPL):
Buy 1 Apple February 395 call @ 14.60
Sell 1 Apple February 405 call @ 10.20
Net debit 4.40
In this example, Apple is trading around $391. With 40 days until February expiration, the trader buys the 395405 call spread for a net debit of $4.40, or $440 in actual cash. Or one could simply say the trader paid $4.40 for the 395405 call.Consider the possible outcomes if the spread is held until expiration.Exhibit 9.1 shows an at-expiration diagram of the bull call spread.
Before discussing the greeks, consider the bull call spread from an at-expiration perspective. Unlike the long call, which has two possible outcomes at expiration—above or below the strike—this spread has three possibilities: below both strikes, between the strikes, or above both strikes.In this example, if Apple is below $395 at expiration, both calls expire worthless. The rights and obligations of the options are gone, as is the cash spent on the trade.
In this case, the entire debit of $4.40 is lost.If Apple is between the strikes at expiration, the 405-strike call expires worthless. The trader is long stock at an effective price of $399.40. This is the $395-strike price at which the stock would be purchased if the call is exercised, plus the $4.40 premium spent on the spread. The break-even price of the trade is $399.40. If Apple is above $399.40 at expiration, the trade is profitable; below $399.40, it is a loser.
The aptly named bull call spread requires the stock to rise to reach its profit potential. But unlike an outright long call, profits are capped with the spread.If Apple is above $405 at expiration, both calls are in-the-money (ITM).If the 395-strike calls are exercised, the trader buys 100 shares of Apple at $395 and these shares, in turn, would be sold at $405 when the 405-strike calls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40 debit spent on the trade and the net profit is $5.60 per share. There are some other differences between the 395405 call spread and the outright purchase of the 395 call.