Sleep Well at Night with the Vertical Credit Spread
Option Selling Institute
Discover how to Target High ROI with Limited Risk
You’ve done your research. You’ve selected your options. You sold a group of calls at strikes you feel the market can never reach. You sit back and wait to enjoy the profits.
But the market has other ideas.
30 days later, prices are moving higher. It’s nowhere near your strike, of course. But the value of your calls are increasing. You’re feeling some pressure.
…selling covered options can make an excellent “bread and butter” strategy for you if you’re focused less on the “action” of trading and more on a stable, consistent annual return.
On one hand, your strike is in no immediate danger of going in the money and will almost certainly still expire worthless. On the other, you don’t feel you can just hold on forever while the options continue to increase in value.
This is where many novice option sellers run into trouble.
“So,” you think, “what do I do now?”
There are a number of different things you can do. But one such choice may be to avoid such dilemmas in the first place. You can do this by selecting the vertical credit spread as your option selling strategy and avoid the stress and effort of adjusting your position later.
Covered Options to the Rescue
In the latest edition of The Complete Guide to Option Selling (McGraw Hill, 2015) , you will find 3 full chapters discussing option spreads – some of which can be described as “covered” option selling.
Selling covered options (credit spreads) is an alternative strategy to selling options naked. While both strategies have pros and cons, selling covered can be considered a more conservative approach. For our purposes here, covered means BUYING an option to “cover” the risk associated with your short option.
Covered option selling can offer many of the same benefits as selling naked, yet without the unlimited risk that makes many investors squeamish. This is why selling covered options can make an excellent “bread and butter” strategy for you if you’re focused less on the “action” of trading and more on a stable, consistent annual return.
Covered options can reduce margin and risk and in some cases, totally limit your risk to an absolute amount. Yes, you can sell options and have limited risk!
And if limited risk is what you seek, there is none more basic or effective as the Vertical Credit Spread.
The Vertical Spread
A vertical option credit spread can be written usingcalls (if you’re bearish the market) or using puts (if you’re bullish the market.)
For instance, if you’re neutral to bearish a certain commodity, you can go far above the market and sell a call option. You then take part of the premium you collected and BUY a more distant option. This is called your “protection.”
Vertical spreads are built to protect you against adverse market moves.
Thus, if the price of the underlying moves up (against you), the option values will tend to move together (although not in lockstep), mitigating temporary losses while you wait for the market to reverse or simply run out the time on your options. Vertical spreads can buy you a lot of time to be wrong .
In a worst case scenario, you can even let your credit spread go IN THE MONEY, and still know that your maximum risk is finite and limited to the distance between your two strikes.
To illustrate, lets take an example:
Example of a Vertical Call Credit Spread in Commodities
The Vertical Bear Call Spread
Scenario: You are neutral to bearish the coffee market in November.
You sell a March 1.60 coffee call and collect a premium of $1100. You then take part of your collected premium and buy aMarch 1.70 coffee call for $500.The net credit of $600 ($1100-$500) would be your profit if the options expire with March Coffee anywhere BELOW 1.60 per pound.
The maximum loss on this trade would be $3,150. That is, the dollar difference between the two strikes (10 cents x $3.75 =$3750), minus the net credit collected ($600). This maximum loss would only be realized if March Coffee futures were above 1.70 at expiration. The profits from the purchase of the 1.70 call would cover any losses below that level. While it does provide limited risk, one would not necessarily have to hold this spread to it’s maximum loss capacity (nor would any reasonable trader want to). The spread can be bought back at any time prior to expiration.
If a trader is bearish a market, he can utilize this same strategy using call options. Thus a bear call spread.
Benefits to Covered Vertical Spread
The primary benefits of the bull put (bear call) spread are threefold.
1. Peace of Mind
It allows you to know your worst case loss scenario. In other words, you can sleep at night.
2. Staying Power
The spread allows you staying power in the market. For you, this can mean less early exits of trades and eventually more going into your premium bucket . The worst case scenario mentioned above is highly unlikely. However, temporary market pressure is always a possibility. Suppose March coffee began rapidly rising in price. The 1.60 call option will likely begin increasing in value. However, so would the 1.70 call option. If you were naked the call at 1.60, odds are good you’d be in the dilemma presented at the beginning of this column. However, with the covered position, the 1.70 call would be increasing in value almost as rapidly as the 1.60 call. Therefore, profits from the long 1.70 call are making up much of the loss on the short 1.60 call. For this reason, in most cases, you can hold the call spread in adverse market conditions, up until the time the underlying contract approaches or even slightly exceeds the short strike and still exit the position with a controlled or even minimal loss.
3. High ROI
The third and possibly most enticing benefit of writing bull put (or bear call) spreads is the attractive margin treatment it gets from the exchanges. By writing this kind of spread, you may initially believe you are “sacrificing” premium or somehow accepting less in order to “buy protection.” Yet, by buying the protective call, you convert your position from one of “unlimited” risk to finite risk. Therefore, the exchange lowers the margin substantially for these types of positions. If you would have entered the call spread illustrated above at the premiums listed, the margin on the spread was approximately $850. That’s a 70% return on capital should the options expire worthless. That doesn’t sound like a sacrifice to me.
Drawbacks of the Vertical Spread
No strategy is perfect and should you elect to use the vertical credit spread, you should be aware of their drawbacks.
First , vertical credit spreads must typically be held through or close to expiration before full profit can be realized. This means that unlike a naked option that is a bit more versatile, you will typically have to stay in your credit spread longer to realize your full premium.
Secondly , spreads between option strikes can vary based on volatility. Thus, this kind of credit spread is not always a practical alternative.
Lastly , a bear call or bull put spread must often be sold slightly closer to the money than a naked option in order to collect a similar premium.
These drawbacks, however, are the trade off you make for the added layer of safety a vertical spread provides.
Vertical credit spread can be a risk averse and reliable method of collecting option premium, especially in volatile markets.
While selling naked can be advantageous in some circumstances, credit spreads offer an alternative tool you can use to build a solid, risk conscious option selling portfolio. It’s a tool that can enable you to take advantage of the high percentage of options that expire worthless every month. And you’ll always sleep well at night.