Target Higher Yields and Limited Risk with Vertical Option Credit Spreads
Part of our Seminar Series, Michael Gross describes selling put options or selling call options as part of a vertical credit spread. Also learn how selling this kind of option credit spread in commodities such as corn or crude oil can be a high percentage option trading strategy that can also serve as a diversified income strategy.
Hi, this is Michael Gross of OptionSellers.com here with your bi-monthly Option Seller Email Seminar Video. The subject of this week’s video is Selling the Vertical Spread. The vertical spread is also known as a bull put or bear call spread. It’s one of our favorite strategies. It’s also a strategy we discuss thoroughly in our book, The Complete Guide to Option Selling, which you of course can get on our website. Now, a lot of people say, “Why would I want to use a spread? You talk a lot in your book about selling options naked. What are the reasons for using a spread?” Well, that’s a good point. We start off, when introducing option selling, we talk about the naked sale.
Here is my standard chart. Here’s your price chart. Bullish I sell a put and bearish I sell a call. It’s simple, but a lot of people say, “Well, what happens if the market keeps going down when I sold my put or it keeps going up when I sold my call? I have unlimited risk.” Well, that’s true. We’ve covered before some of the best ways to manage your risk on naked options. There is a place for naked options in portfolios, it’s still one of our favorite strategies to recommend, but there are also times where it can benefit you sometimes greatly to sell a credit spread. What’s a credit spread mean? A credit spread simply means you’re combining selling and buying options with the net result is you’re still taking in a premium. So, if everything expires, which is what you want, you’re still collecting a premium.
A vertical spread is a kind of credit spread. Now, let’s define vertical spread first before we go any further so you know what we’re talking about here. Here’s our price chart again. Let’s say we want to sell a call… we’re selling crude oil. Good example to have right now. Crude oil has been in the news. A lot of people are wondering where the bottom is, but let’s just say right now you’re bearish crude and you don’t think it’s going to go up. You don’t know if it’ll keep going down, but you don’t think the upside potential is very good over the next 90-120 days. So, you’re going to sell, this is just an example as I don’t have the prices in front of me, crude is trading at $50 a barrel. You don’t think it’ll go to $70 any time soon; however, the market does jump up, you think it might be getting a little volatile here, the value of that $70 call could move on you maybe quicker than you’re comfortable with, right? Instead of just selling the $70 call here and, again, example purposes here, let’s say the value of that call is $800. You’re going to sell a May $70 call, okay?
Rather than just sell the call naked, you’re going to go and here’s the $80 strike level. You’re going to go up and sell your $70 call, take in an $800 premium, but then you’re also, at the same time, you’re going to go up here and you’re going to buy an $80 call. So, you’re selling the $70 call and you’re buying the $80 call. Let’s say to buy that it’s going to cost you $300. What does that do for you? Well, it does two things. You took $300 of the premium you collected and you bought your $80 call. That offers you one big advantage…. Protection. You’re not naked anymore, you’re what’s said as covered. This is an example of a bear call spread, because you’re bearish oil, neutral to bearish oil, so you’re selling calls to take advantage of it. It’s a vertical spread because the options go vertically on the chart…. You’re selling $70 and $80 calls. The difference between these two is your credit, $500. So, if everything expires worthless, you’re keeping that $500 as your net collected premium.
The big advantage is if tomorrow, all of the sudden, Israel bombs Iran then oil prices start going like this and you have protection. Now, typically you sell this spread not with the intention of the thing going in the money, you still don’t want it to go into the money, but if it does make a big jump, say oil jumps $10-$15 a barrel in the next 30-60 days and it’s up at $60-$65 a barrel, these two strike prices are both gaining in value. So, yes, this one’s going to be moving against you but this one’s going to be moving for you. What does that do for your position? It slows the market down. So, if you have a naked call and, granted, naked calls aren’t moving as fast as a regular market typically, so you’re slowing the market just by selling calls or puts in general.
I don’t want this to make you afraid of selling naked because selling naked can be a great strategy at time, but this is a more conservative strategy. It does slow the market down. Even in adverse moves, this protection here is going to really slow how the market moves against you, if it is moving against you. If the thing does go in the money, the benefit of a vertical spread is it does give you an absolute limited risk. If the thing goes above $80, your risk is limited to the difference between $70 and $80. It’s still a pretty good spread and you don’t want to let it go in the money, but it does give people peace of mind of knowing that they do have a limited risk on the trade. The biggest advantage is it’s moving slower against you. The market can move further against you and you can still stay in your position.
I’m going to get rid of this and let’s summarize the advantages and disadvantages of a vertical spread. I’m going to check my notes here to make sure I convey this to you properly. So, one, advantages of the vertical spread is limited risk. Limited risk = Peace of mind, which is you can’t put a price on peace of mind. That’s one reason a lot of people like vertical spreads. Second big advantage, we already talked about, slows the market down, which gives you staying power. One of the reasons we sell options is we can stay in the market even if there’s a somewhat adverse move against the position. It lets you stay in the market much longer, gives that option still plenty of time to expire, gives you time to still be successful and make money on your trade rather than get stopped out. A vertical spread takes that to another level, allows you to stay in your trade even longer in an adverse move, it allows you to ride out those type of waves longer and further, which is what you want to do because the whole point of selling options is you want to be able to stay in until expiration. The longer you can stay in the better it is for you and the more time value has a chance to work on that option. That’s what you want.
The third big advantage, and we haven’t talked about this one yet, the third big advantage is potentially larger ROI (return on investment). A lot of people say, “Well, that doesn’t make any sense. If it’s a more conservative strategy, wouldn’t the return on investment be lower?” Not necessarily. The nice thing about selling a limited risk position, the exchanges consider that a more conservative position and, thus, the margins can often be lower. If you sell a protective call on a short option, which we’ve just discussed on a short call position, your margin requirement goes down. Now, granted, it costs a little more because you have to buy that option and give up some of your premium, but often times, even when you do that, the premium to margin ratio can be lower than selling a naked position. So, you’re actually getting a larger return on your invested margin than you would be in a naked position. Now always and not all the time, but enough to make it worthwhile. In fact, when we’re looking at a position, the first thing we look at is a credit spread. We don’t necessarily always look for a naked position and you shouldn’t either. If you’re looking to trade, I would look to see if credit spreads are available.
Now, that brings me to the last part of our seminar here, which is the drawbacks of selling vertical spreads. There is no free lunch in investing and there’s no free lunch in selling options. Every strategy you use, despite its benefits, there are drawbacks. You should know them before employing the strategy. The drawbacks to writing a vertical spread, there’s two main ones you should be aware of. The first drawback you’re going to have to be dealing with is typically in a vertical spread if you’re right on the trade, the trade is moving neutrally or it’s moving in your favor. If you’re in a naked position, if that option decays enough you can easily buy out of it and get out of the trade early. Typically with a vertical spread, to get your premium and to get the most premium out of it, since those options are moving together, the spread (we’ve already talked about it) moves slower when it’s moving against you but it also moves slower when it’s moving for you.
So, one of the drawbacks is you typically have to stay in a vertical spread, if not through expiration, pretty close to expiration to get most of your premium out. Plus, you have to buy two options back and, depending on what they’re offering for them, sometimes it’s just worth it to let them expire and get all the premium that way. So, you have to stay in the trade longer. Now, that’s not a big disadvantage, but if you’re really looking to capitalize if you’ve got a hot trend and the thing is moving for you, often times you want to keep selling those premiums to get them while they’re there. So, it’s just something to be aware of and it’s something you give up to sell the vertical for that extra safety.
The other thing, and this is also a big deal is, vertical spreads, credit spreads, they’re not always available at the premiums you might want. We did that example where your crude option is not always available, for those of you taking notes. If we go back to our crude example, we sold a $70 call, we bought an $80 call. The difference between the two is $500. That’s an acceptable, might be acceptable, typically we’re going to be looking for larger spreads than that, but for some people a $500 spread is not bad… $10 for the risk is not bad. That might not always be there. If that goes down to $200, the difference between those two strikes, would it still be worth your while? It’s lower risk, but you’re still taking quite a bit of risk there to make $200. I’m not sure I would take that spread. We’re typically looking for wider spreads and you have to balance the premium you’re taking versus the distance between those two strikes. I can’t get into it here… we could take about it all day. It’s covered thoroughly in The Complete Guide to Option Selling if you’d like to read it.
I’m going to wrap up the seminar there. You can read the rest in the printed version. If you do want to get the book if you haven’t read it yet, you can get a special offer on our website right now. It’s www.OptionSellers.com/Book. You can get it at a 40% discount off cover price, so it’s going to be less than you’re paying at Amazon or in the bookstore. It’s something you might want to check into. Also, for those of you out there that have been watching our videos and you might have got our booklet in the mail, schooling you on this, if you’d like to learn how to work directly with us or how to apply to work directly with us, we do have an Option Seller Discovery Pack. It’s for high net-worth investors. If you’d like to get one of those, feel free to call our office. You can also register online at www.OptionSellers.com/Discovery . If you have any interest in learning how to work directly with us, this packet will explain how you can possibly do that, how you apply, our selection criteria for who we work with, and feel free. It’s free, there’s no obligation, so feel free to request that at any time. Thanks for coming to this week’s Option Seller Email Seminar. We’ll see you next month.