Increase Odds And Reduce Risk With Vertical Options Spreads

Includes: IWM, SPY
by: Michael Thomas

Options spreads provide traders with a relatively less risky method of placing bets on equities as opposed to buying those equities outright. It also results in less capital outflow as options require much less upfront cash from the trader to achieve the same gains, and losses. An option allows a trader to control, but not own, 100 shares of the underlying equity at a fraction of the cost to own 100 shares. This article discusses debit vertical spreads that allow directional trades with a defined maximum risk, profit, and timeframe for the trade to be unwound.

One of the major benefits when dealing with options is leverage. You can achieve great returns while not having to put up a lot of capital to do so. Consider making a trade on SPY, an ETF that tracks the S&P500 index. The capital required to purchase 100 shares of SPY will require a trader to put up around $14,600, or half that amount on margin. A trader could instead control, but not own, 100 shares of SPY by putting up as little as $100 in order to buy a call option. This amount can vary depending on the specific strategy employed by the trader with regard to strike price and expiration of the call option. Regardless, it's easy to see that a substantially less amount of capital is required to trade this equity through use of an option.

One of the drawbacks from just going long or short equities through use of call and put options alone is the negative effects of time decay. There can also be negative or positive effects from changes in volatility. One way to compensate for the effects that work against an options buyer is that they can sell a higher strike call or lower strike put to create a spread. This not only combats time decay and volatility changes, it lowers the net cost to open a trade. If the calls or puts used in creating the spread expire in the same month this is referred to as a vertical spread. If the options expire in different months it becomes a calendar spread.

Not all equities are suitable for trading options. There must be sufficient liquidity for a particular equity in order to effectively trade options. Low liquidity usually leads to large bid/ask spreads on options that make it difficult to enter profitable trades. It is best to stick with equities with sufficient volume where options spreads are kept to a minimum. Bid/ask spreads pose an even bigger issue for spread options traders as they have to overcome two bid/ask spreads, one on the long call/put and one on the short call/put.

An example of how this options strategy works based on a real trade opened on 9/28 and closed on 10/5 involving IWM, an ETF that tracks the Russell 2000 index. A bullish October 83/85 option spread was opened on September 28, by buying the 83 strike calls for $154 and selling the 85 strike calls for $60. This resulted in a net debit trade of $94 per contract and represents the maximum loss that can result in this trade per contract. IWM shares were trading around $83.33 when the options position was entered. The position was closed on October 5, when IWM shares were trading around $84.77. The 85 strike calls were bought back at $95 and the 83 strike calls were sold at $230 for a net credit of $135 per contract.

Simple math on the above example shows that the option trade produced a net gain of $41 per contract. This yields a return of 43% in six trading days, not including commissions, which will vary depending on brokerage costs and the size of the trade. This particular trade involved options with a relatively short expiration, which was less than one month when the trade was opened.

Time can be an option trader's worst enemy or best friend. Owners of options have time working against them and sellers of options have time working for them. Time can also, however, be an options owner's friend. When vertical spreads are used and the effect of time decay is dampened by a corresponding short option position hedging the long option position, longer time periods can provide an advantage. Suppose a question was posed as to whether or not SPY would hit $148 within the next 30 days. A bullish view would say that there is a high probability that at some point within the next 30 days SPY will hit $148 a share. Now suppose the same question was posed except that the timeframe were increased to say 180 days, meaning that at some point within the next 180 days SPY would hit $148 a share. That same bullish view would have to assume an even higher probability of hitting this price target given the expanded time frame.

Liquidity in options may be the overriding factor when determining the expiration month used to open a trade. Generally speaking, the longer out the expiration month of an option, lower liquidity is encountered and the higher the bid/ask spread. However, a trader may find that there is substantially the same bid/ask spread on options trading as far out as six months. The key point is a balance needs to be kept in choosing expiration months to give a trade maximum time versus keeping bid/ask spreads reasonable.

Strike prices selection for vertical spreads depends on how bullish, or bearish, a view is placed on the underlying equity. Spreads can be opened covering several strike prices or just a few. As the separation in strike price gets larger, the maximum profit target increases at the expense of increasing the cost of the trade. However, selling multiple smaller spreads can result in the same profit target without requiring a larger move in the underlying equity.

Trading spread options generally requires a margin account with level 3 trading approval, which may vary by brokerage. Commissions and bid/ask spreads can cut deeply into profits, and enhance losses, in this type of trade so it is important to consider these costs before opening any position.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SPY over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.