Vertical Debit Spread Explained

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Key Concepts Options Strategies

Vertical Spread

A long call vertical spread is a bullish, defined risk strategy made up of a long and short call at different strikes in the same expiration.

Directional Assumption: Bullish

– Buy ITM Call
– Sell OTM Call

Ideal Implied Volatility Environment: Low

Max Profit: Distance Between Call Strikes – Net Debit Paid

How to Calculate Breakeven(s): Long Call Strike + Net Debit Paid

Long Put Vertical Spread

A long put vertical spread is a bearish, defined risk strategy made up of a long and short put at different strikes in the same expiration.

Directional Assumption: Bearish

– Buy ITM Put
– Sell OTM Put

Ideal Implied Volatility Environment: Low

Max Profit: Distance Between Put Strikes – Net Debit Paid

How to Calculate Breakeven(s): Long Put Strike – Debit Paid

Short Call Vertical Spread

A short call vertical spread is a bearish, defined risk strategy made up of a long and short call at different strikes in the same expiration.

Directional Assumption: Bearish

– Sell OTM Call (closer to ATM)
– Buy OTM Call (further away from ATM)

Ideal Implied Volatility Environment: High

Max Profit: Credit received from opening trade

How to Calculate Breakeven(s): Short call strike + credit received

Short Put Vertical Spread

A short put vertical spread is a bullish, defined risk strategy made up of a long and short put at different strikes in the same expiration.

Directional Assumption: Bullish

– Sell OTM Put (closer to ATM)
– Buy OTM Put (further away from ATM)

Ideal Implied Volatility Environment: High

Max Profit: Credit received from opening trade

How to Calculate Breakeven(s): Short Put Strike – Credit Received

Vertical spreads allow us to trade directionally while clearly defining our maximum profit and maximum loss on entry (known as defined risk).

While implied volatility (IV) plays more of a role with naked options, it still does affect vertical spreads. We prefer to sell premium in high IV environments, and buy premium in low IV environments. When IV is high, we look to sell vertical spreads hoping for an IV contraction. When IV rank is low, we look to buy vertical spreads to stay engaged and also use it as a potential hedge against our short volatility risk.

Since the maximum loss is known at order entry, losing positions are generally not defended. We always look to roll for a credit in general, and doing so with vertical spreads is usually difficult.

When do we close vertical spreads?
Profitable vertical spreads will be closed at a more favorable price than the entry price (goal: 50% of maximum profit

When do we manage vertical spreads?
Losing long vertical spreads will not be managed but can be closed any time before expiration to avoid assignment/fees.

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How Can I Exit A Vertical Option Spread Without Getting Creamed?

Pretty normal question to ask. You have a vertical option spread that you need to exit but you don’t want to get creamed getting out of the position.

Even for the most experienced traders this can be a tricky path to walk. So in this article, I’ll try to help explain how you can safely look for the exit doors without seeing your profits evaporate.

Let’s Start At The Beginning

First we need to quickly talk about the Vertical Option Spread. And for simplicity we are only going to cover Debit Spreads in this article. For this trading strategy you make a simultaneous purchase and sale of two options of the same type (Call/Put) that have the same expiration dates but different strike prices .

Depending on your market bias, you could create a Bullish Spread or a Bearish Spread – both with either Puts/Calls. As you now options are very flexible. Let’s use this simple example for our purposes:

Bullish 150/160 Vertical Call Spread

In this example we are assuming you BUY a Call with a strike price of $150 for $100 and at the same time SELL a Call with a strike price of $160 for $70 = a net debit (or cost) of $30 per spread.

Naturally the $150 Call is closer to the money than the $160 Call and costs more, so you are using the proceeds from the short $160 Call to help pay for the long $150 Call.

The overall goal of a trade like this is that the market will continue higher past $160 by expiration at which point your $30 investment turns into a great profit. However, as well all know, when you try to predict the market direction things can and will go wrong from time to time.

Start The FREE Course on “Trade Adjustments“ Today: What happens when a trade goes bad? Do you roll out to the next month, move your strike prices, add/remove one side or do nothing at all? We’ll give you concrete examples of how you can hedge different options strategies. Click here to view all 15 lessons ?

The Trade Goes Wrong – Now What?

For one reason or another things don’t go your way right? Either the stock didn’t go higher or it made a late move and now expiration and time decay are eating away at the premiums. Whatever the case, there are a number of ways to manage bad trades in a market like this. Here are my “preferred methods.”

Each depends on market conditions so keep them all handy and use the one that fits best for your trades.

1) Scaling Or Legging Out

Scaling out of the position on strength is my favorite technique. If the stock continues to rally but you know it will never hit your target, then buy back the short $160 Call early and take advantage of any upside move with the $150 Call.

If the move stalls and starts trading sideways or heading lower then do the opposite. Buy the $150 Call and savor whatever premium you can get while leaving the short $160 open. Here you will take advantage of the remaining time decay of the short call.

2) Set Trailing Stop Loss Orders

For the beginner trader this will probably work best as it’s very easy to use and understand. Legging into and out of trades can become very complex and may require some additional trading experience. But stops are always great tools for any trader and have saved me multiple times.

What you would do is set a trailing stop loss order just below the market price. So let’s say the spread is now worth $20 (instead of the $30 when you bought it). You could set a $10 trailing stop loss order meaning that if the spread increases in value then the stop order moves up and keeps locking in your profit. If market turns around quickly then it will get you out of the trade at $10 and savior what could have been a 100% loss on the trade.

3) Reverse The Trade Completely

I typically don’t favor this strategy because you are “giving up” on the trade completely. When you reverse the trade you are going to be selling the $150 Call and buying back the $160 Call. Whatever you get for the option premiums is what you get.

I have left this for the last option because when you reverse the trade you are not leaving any possibility for stretching the trade and making the most of a bad position. Over the years it’s the traders who find an extra $5 or $10 here and there in bad trades that end up making more money. Even bad trades can still turn around and lose LESS than you expect if you were to close out the trade completely.

What Am I Missing Here?

There are multiple ways to enter and exit trades depending on the market you are trading in. So what has worked for you in the past that you can suggest to everyone else? Add your comments here if you have questions or want to suggest another angle for exiting vertical option spreads.

Are Debit Spreads Better Than Credit Spreads?

Here are some misconceptions about credit spreads:

  • “One of the many drawbacks of a credit spread is that it will tie up so much capital.”
  • “Selling credit spreads is like picking up pennies in front of a steam roller.”
  • “Credit spreads are different from debit spreads. One has a low probability of success, the other has a high probability of success.”

I hope that after reading this article, some of those misconceptions will be cleared.

The trigger for this article was a conversation I had on Twitter with one of my followers. Here is a snapshot:

Same Probability? You Bet!

The link in my tweet pointed to one of my previous articles where I clearly demonstrated that credit spreads are in fact the same as debit spreads if using the same strikes.

I guess that one picture is better than thousand words, so lets try to visualize the concept.

Lets try to construct a RUT credit spread having

80% probability of success. Using August 2020 expiration and July 10 closing prices, we can do the following trade:

  • Sell Aug. 2020 RUT 1210 call
  • Buy Aug. 2020 RUT 1220 call

The risk profile looks like this:

As we can see, we get $185 credit for this trade, our margin is $815 ($1,000-185) and maximum gain is 22.7% (185/815). The maximum gain is realized if RUT stays below 1210 by August expiration.

As shown in the chart, the breakeven point is 1211.76 and probability of success 79.5%.

Now lets try to construct the same trade with puts. The trade will be:

  • Sell Aug. 2020 RUT 1210 put
  • Buy Aug. 2020 RUT 1220 put

The risk profile looks like this:

In this trade, we are paying $815 and our margin is the same as the debit ($815). The maximum gain is realized if RUT stays below 1210 by August expiration, in which case the put spread will be worth $1,000. The maximum gain? 1000-815=185, so 185/815=22.7%, exactly the same as with the credit spread. As shown in the chart, the breakeven point is 1211.76 and probability of success 79.5% – again, exactly the same as with the credit spread.

There might be some practical reasons to prefer one trade over another. In our example, the credit spread is constructed using OTM (Out Of The Money) options, that tend to be more liquid and have tighter bid/ask. So while “theoretical” prices might be the same, in practice you might get better fills (which means better probability of success) with the credit spread. In addition, OTM options don’t have assignment risk, while ITM options do. That means that you always have to close the ITM spreads before expiration, while with OTM spreads, you can just let them expire. Of course assignment risk is relevant only to American style options. European style options like RUT, SPX etc. can be exercised only at expiration and don’t have assignment risk.

The bottom line:

The trade can be constructed by selling lower strike and buying higher strike. When using calls, we will get a credit. When using puts, we will pay a debit. But if the same strikes are used, this is exactly the same trade. Same risk profile, same maximum gain, same probability of success, same breakeven point.

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    Vertical Debit Spread Explained

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    Going vertical with debit spreads

    Credit spread strategies have a strong following for obvious reasons. A main component of option premium is time, and option traders would rather have time on their side. Indeed, credit spreads are constructed to take greater advantage of this time decay. In addition, credit spreads may be designed to have a high probability of success. However, with the high probability comes a relatively low reward compared to the significantly higher maximum loss potential.

    Credit spreads involve selling the higher-priced option and buying the cheaper option for protection. This has the psychological advantage of starting off net-positive in terms of premium. Debit spreads involve buying the higher-priced option and selling the cheaper option. The most that can be lost on the debit spread is the amount that was paid. Because of this reason, debit spreads are considered to be a more conservative strategy vs. a credit spread.

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    Here, we’ll take a closer look at bullish and bearish vertical debit spreads. For these spreads to profit, the underlying stock will have to gain or lose value accordingly, making vertical debit spreads a directional strategy.

    Pros & cons

    The first advantage of a vertical debit spread is cost. It is less expensive than buying in-the-money (ITM), at-the-money (ATM) or just slightly out-of-the-money (OTM) options.

    This advantage is all too clear, especially for expensive options with high implied volatility that usually accompany high-priced stocks. Google (GOOG) is a relatively high-priced stock by most traders’ standards, and the options can be very expensive as well. If a vertical spread is implemented in which options are both bought and sold, the cost of the trade can be reduced dramatically.

    The stocks and options don’t necessarily have to be expensive to use a vertical debit spread. The benefits can be utilized for cheaper stocks and options as well.

    A disadvantage of lowering the cost with a vertical debit spread is that maximum profit is defined and capped. With long options, maximum profit is theoretically unlimited. With a vertical debit spread, the maximum profit is capped by the option that was sold. No matter how much the stock moves past the sold strike, the option buyer most likely will exercise the right to buy or sell the stock at the strike price, negating further gains.

    Another advantage of a vertical debit spread is that if the underlying stock moves counter to the position, the spread will lose less than a straight call or put because of a smaller delta and initial costs.

    The trade’s delta is smaller because the positive larger delta of the long option is offset partially by the smaller negative delta of the short option. For example, say XYZ stock is trading at $40 a share, and an option trader purchases an ATM call option (40) with a delta of 0.50. For every dollar XYZ goes up or down, the call option should increase or decrease by 50¢. If a vertical spread were created by selling a call with a strike price of 45 and delta of 0.20, the delta for the spread would now be 0.30 (0.50 – 0.20). Now the spread would gain or lose 30¢ for every dollar the stock went up or down.

    Delta will increase the closer the options get to expiration. The more an option is ITM, the larger the delta will be. Of course, the downside to lowering the overall delta is obvious. If the trader is correct on the movement and the stock never hesitates, more profit could be made just by being long the option.

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