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Lesson 9: Vertical Spread

Vertical Spread, Options, Options strate

Vertical Spread, Options, Options strategy, Options courseWe have seen in the previous article that selling options is advantageous from the point of view of time and probabilities, but presents risks that are potentially unlimited.

The first step to protecting our trade is to put a stop loss. For example, we sell a PUT option on Amazon with a premium of $ 1.00 (it means we get $ 100.00 from this sale) we can put a stop loss on the option at $ 2.00 or $ 2.50 or $ 3.00… What we think is the right level.

Put a stop loss, however, is not always enough. It may happen that the next day an underlying opens with a gap up/down or there is a strong movement of a 10% or 15% and our stop is skipped without being able to run, resulting in big losses.

Many people think that stop loss is something automated and that it must work necessary, but that is not the case. Following the news, central bank decisions, political events, and so on, a market can make a strong movement that goes to skip all stop loss causing heavy losses.

Just you think in January 2015 when the Swiss Central Bank unhooked the Swiss Franc from 1.20 against the Euro. All those who were long at that time for the currency pair (but also on CHF against the other major currencies) suffered heavy losses; even several brokers were forced to declare bankruptcy (such as Alpari) or risked having to do so (such as FXCM). How can we prevent this from happening?

What we can do to shelter us from any jumping stops following strong movements is to cover us by going to buy another option with the same expiration but with the strike.

Let's see better an example. We decide to sell a CALL option on Apple strike $ 150.00 and expiration on January 19, 2018. The market accords us a premium of $ 120.00. At the same time we buy a CALL option same expiration but with strike $ 145.00 (a bit more OTM than sold CALL option) for which we will pay a premium of $ 50.00 to the market.

What we did in the above example has a name and is a precise strategy, called Vertical Spread. A Vertical Spread is built by selling an OTM option and buying another option even more OTM.

With this strategy, we have limited the maximum loss that will be given by:

Max Loss = (high strike – low strike) *100 – premium received

Returning to the example of Apple, the maximum risk and, then, the maximum loss on strategy is given by:

Max Loss = ($ 150.00 – $ 145.00) * 100 – $ 70.00 = $ 430.00

In case we had sold an OTM PUT option and bought OTM PUT option, the maximum risk in the same way.

As a rule, therefore, at the difference between the two strikes multiplied by 100, we have to remove the premium received, and we get our maximum risk, the maximum loss we are facing with that trade.

As you have seen, with this strategy, we are selling an option, and in the face of a slightly lower premium, we have a limited maximum, and now this does not frighten us as before.

Vertical Spreads can be of two types depending on whether we want to sell a CALL option or a PUT option:

  1. Bear Call. It consists of selling a CALL option OTM and buying another CALL option even more OTM. It is said, in this case, that we are not bullish.
  2. Bull Put. It consists of selling a PUT option OTM and buying another PUT option even more OTM. It is said, in this case, that we are not bearish.

In the next article, after the Christmas season, we will see some examples for understanding better this simple but effective strategy.

 

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