Vertical Credit Spread: A beautiful strategy for the income traders

by OptionPundit on January 29, 2007

When looking for benefiting from theta in combination to speculating on a stock’s direction, you may want to hedge your predictions and that’s where vertical spreads are very useful. These can be done for a debit or credit. Once one understands how vertical spread works, one will notice what a wonderful trading strategy it is. In this article, I am going to focus on vertical credit spread. Later I shall talk about, how one can construct some other wonderful strategies just by looking at various alterations of vertical credit spread.
 

What is a Vertical Credit Spread: An option trading strategy which includes the sale of a closer-to-the-money option (higher-priced) with the purchase of a further out-of-the-money option (lower-priced) with the same expiration date on a one-to-one basis.
 

What does it mean: Bullish credit spread will use short put verticals, which is buying an option at a lower strike price and selling an option at a higher strike price. Bearish spread will use short call verticals, which is selling an option at a lower strike price and buying an option at a higher strike price. You profit when the stock either does not move at all, or moves in the correct predicted direction. This options trading strategy is a perfect “limited risk/limited return” technique for traders looking to take advantage of strong support or resistance points on the underlying stock and overpriced option premiums. The advantage of using vertical spreads is defined-risk, risk-based reduction of buying power, tight markets for liquidity and good executions, as well as easy to understand breakeven points.

In a variety of market conditions, from relatively low to high volatility, and from strongly trending to range-bound prices, verticals are extremely attractive as a low cost alternative to buying and selling individual options.

EXAMPLE: Take a look at what the order looks like on a Vertical Credit Spread on the stock PCP where I bought 1 put option with a strike of 80 and sold 1 put option with a strike of 85. The result is a complete trade that gives me a 1.25/contract ($125) CREDIT to my account (for each contract I choose to do).

The price of PCP at the time of this trade was around $86. I need to consider one key point here, and that is margin, which is defined as “Difference between strikes minus credit received”. In this example it is $85-$80-$1.25 = $3.75. If by Feb 17, PCP remains above $85, I will keep all the credit and my returns will be $125/$375 i.e. 33.3%. My breakeven point is 85-1.25=83.75 and if it falls below $80, I will have max loss of $3.75 per contract on expiration day.
Here is the chart that explains it little more: 

The price of PCP at the time of this trade was around $86. I need to consider one key point here, and that is margin, which is defined as “Difference between strikes minus credit received”. In this example it is $85-$80-$1.25 = $3.75. If by Feb 17, PCP remains above $85, I will keep all the credit and my returns will be $125/$375 i.e. 33.3%. My breakeven point is 85-1.25=83.75 and if it falls below $80, I will have max loss of $3.75 per contract on expiration day.Here is the chart that explains it little more: 

As with any strategy, run a thorough rish/reward analysis and assess if you are comfotable with the trade and know how to adjust when things go against you. Hope you enjoyed reading this. Do write your comments. In the next article on credit spread I shall share how can this be altered to create ven other winning strategies.

Porfitable trading, OptionPundit

Share the knowledge.

15 Responses to “Vertical Credit Spread: A beautiful strategy for the income traders”

  1. Dan Schneider says:

    Nice piece on credit spreads. What is your favorite way of doing risk/rewaed analysis?
    Thanks

  2. omitrademan says:

    Nice easy to understand explaination.
    Can you provide some of your preferred option entry & exit criteria to this strategy (not stock charting or technical analysis).
    e.g. Day to expiration, Risk to Reward lookup etc.

    Thanks

  3. AK says:

    Op

    Do you also play debit verticals? Ie. buying ATM calls/puts and selling OTM calls/puts. This will require us to give debit.

    I have found bear put spread and bull call spread to be quite effective if you want to trade options for expensive stocks such as GOOG, AAPL, BIDU, RIMM etc.

    Your cost of buying ATM or ITM option is largely offset by the sale of the next strike option.

    If the stock moves in your desired direction you can get anywhere from 50%-100% profits. The trick is use this strategy (bull put spread and bull call spread) on stocks with high IV and those that move about $2-$3 in a day.

  4. AJ says:

    Hi optionpundit,
    When you sell an option, do you have to own the underlying stock ?

    Thanks,
    AJ.

  5. optionpundit says:

    Thanks Dan- For credit streads, Risk/Reward analysis is quite simple. I look at the credit received with respect to the margin I need to keep. This all, of course with respect to risk I am taking and how confident I am of my directional bet. For instance, my expectation for Risk/reward for CSCO will be very different from say PD. If I am taking higher risk, I would like to be rewarded nicely. If your question is from software standpoint, I use ThinkorSwim. There are many software available.

    Thanks Omitrademan,
    It is difficult to define entry/exit without the chart. Reason is that I need to look at those to make an entry. For instance, few days back I played PCP for earnings (I posted here) and after earnings as the stock broke-out, I played a BPS for 85/80, which is doing nicely. So it’s a combination. I will exit as soon as I have received at least 75% of my credit. On the downside, I will look at if it’s falling below my break-even point. I also would like to look at Delta that gives me an indicative probability.

    Hi AK- I do play debit verticals. However, in general I like to be paid first and hence play credit spread more than debit. I will surely look at the examples of RIMM, GOOG etc and revert to you with my take on this.

    Hi AJ – If you don’t have stock, you need to have sufficient margins available in your account. If you don’t want to keep that much margin in your account, you can do so by buying option to hedge. That way your broker will require margin based on the difference in strikes, and cost of the trade.

  6. […] Here is an update on closure of my credit spread for PCP which I mentioned here. I opened that trade for a credit $1.25 and with Margin $3.75. The logic for the trade was, directional as it was breaking out of the resistance zone.  I bought back the spread for $0.40 (rationale was that risk/reward was not good now, I wanted to release margin so I can use somewhere else). This credit spread resulted in 22.67% profit for holding period of 1 week. Here is the closure of transaction. […]

  7. […] Credit spreads are the foundation for Iron condor. For more about credit spread, please click here. […]

  8. Rapheal says:

    Hi,
    Can you explain in details how do you find the trade? Is it time or event driven? Do you play index? Is there any difference?
    Happy Trading

  9. OptionPundit says:

    Dear Rapheal,

    Thanks for your kind words, comments and questions. For finding trades, I firstly decide the strategy I want to invest in, then I analyze which underlying will suit the most, define exit and entry criteria and a risk management plan. All these are part of a trading plan (for that strategy) and then I enter into a trade. I do trade based on events as well i.e. news, earnings, dividends etc but those are not my main style of trading. Most of my capital is invested in income trades.

    Regarding your question on Iron Condor Part-2 and 3 etc., I have not written those yet. Market was full of opportunities and I therefore prioritized making money vs. writing articles. Articles can afford being late but opportunities can’t. I plan to write my thought on IC in due course of time so pls stay tuned.

    Profitable trading

  10. Clarence says:

    In a Bull-Put strategy, can you explain what happens when, before option expiration, the price of the
    underlying stock lands in between the Sell and Buy strike prices? Will I be forced to close the Sell position?
    If so, will the broker also automatically close the Buy position to limit the loss since both positions were
    entered as a single spread?

  11. tritrader says:

    Do you find yourself unwinding vertical credit spreads early to take profit off of the table?

  12. OptionPundit says:

    Yes I do it many times tritrader.

  13. Coolio says:

    My strategy: write these on the SPY, DIA, IWM. Write them way out of the money for $.30 – $.50 credit 4-6 weeks from expiration. Then let time decay (theta) do all the work.

    Buy back the short put when it gets to $.05 or below (no fee at my broker)

    Also, sell the put verticals on down days especially when the $VIX is high to maximize the credit and area behind lines of support. Sell into the panic!

    Depending on commish structure, this may or may not work, my broker has ultra low commissions so this works for me, a small timer.

    I call it “selling junk.”

  14. Sri says:

    Imagine I bought AAPL BULL PUT $290 (buy)/$300(sell) resulting a net credit of say $315 and assume that stock is trading at $283. At the expiration, if the stock remains at $290 or under, what happens? if the stock goes over $290 what happens?
    Could you please help with a detailed analysis. I would really appreciate it.

  15. This strategy worked really well for me initially, because these spreads can make money faster on smaller price movements than other strategies I’d used. But one day my stock broke through the support and I had about 2 weeks of gains erased after closing my position! So be careful- I’d say a condor is safer because price can only break through on one side at a time.

Leave a Reply

 

Previous post:

Next post: