Options Strategies

Vertical Spread Overview

A vertical spread is an options strategy which allows option traders to bet on the direction of the market with a limited risk and limited return profile.  Traders utilizing a vertical spread are typically not 100% sold on the direction or strength in the trend.

Constructing a Vertical Spread

A vertical spread can be constructed by buying and selling calls (or puts) with the same expiration date and underlying security, but with different strike prices.  The idea is to go long on one option and short the other to create a bullish or bearish spread. 

Vertical spreads are created by using call options or put options, but not by mixing both together.  A bull call spread or bull put spread can be constructed by purchasing at the money calls or at the money puts and selling out of the money calls or puts to somewhat offset the cost.

Conversely, a bearish vertical spread can also be created with calls or puts.  However, the options will swap positions as far as which one is bought and which one is shorted.  A bear call spread will consist of a short call at the money and a long call out of the money while a bear put spread will consist of a long put at the money and a short put out of the money.

Debit spread versus credit spread

A vertical spread can be put on as a credit or debit on initiation.  It is important to understand why a trader would create one versus the other.  Vertical credit spreads are theta decay plays, entered by traders who believe that there will be very low volatility up until expiration.

For a bull put spread, the trader who shorted the higher strike put will want to see the stock close above that price or very close to the higher strike to make a profit.  Conversely, a bear call spread profits most when the stock closes below or at the strike price of the short option.  These trades have a clear risk and reward scenario.  We just discussed the reward; the risk is equal to the difference between the strike prices of the options minus the net credit received. 

Debit spreads, on the other hand, are taken by traders who want a directional bias.  Bull call spreads make money when the stock moves above the OTM call strike while bear put spreads profit as the stock moves below the lower strike put.  These are more directional trades rather than time decay trades.

Bear Put Spread Overview

The bear put spread options trading strategy is utilized when a trader wishes to bet on the downside in the market with limited risk.  The bear put spread is a low risk, moderately high reward strategy which involves buying an in the money put option and shorting an out of the money put option at the same time.  Both options will have different strike prices but the same expiration date.

Bear Put Spread Risk Characteristics

As depicted below, the risk associated with this trade is merely the net debit paid to initiate the spread.  As you can see in the diagram below, the maximum loss in this trade occurs at the strike price of the ITM Put.  Remember, if the stock closes above the upper strike price, the puts are worthless and therefore the monies paid to put this trade on are lost.

Maximum Risk of Bear Put Spread:  Long Put Cost - Short Put Cost

We mentioned above that this strategy has moderate profit potential.  We used the term "moderate" because we are going long one option and short another.  The short put in this spread will limit the profit potential as the stock moves lower in exchange for a credit which reduces the cost to put the position on.

Therefore, we can calculate the profit potential of the bear put spread with the following formula: 

Maximum Profit Potential:  Strike Price of Long Put - Strike Price of Short Put - Net Debit

Being a net debit transaction, the stock will need to move in the anticipated direction by an amount equal to what you paid to put the bear put spread on.

Breakeven:  Strike Price of Long Put - Net Debit

What is a Married Put?

A married put is a hedging strategy used by traders to protect themselves against the downside risk associated with the underlying security for a predetermined amount of time.  Married puts allows a trader to enter a long position in the stock with a predefined risk tolerance; it is a low risk, bullish strategy protecting against short term downside risks.  The purchase of this put protection will effectively raise the net cost of the stock by the amount paid for the put and therefore will not cap your upside potential as a covered call would.  You will see traders engage in a married put strategy right before an earnings announcement or other major news announcement that could dramatically shift the price of the underlying stock.  For this reason, married puts are usually purchased at the money with a shorter term to expiration.

Married Put Risk Characteristics

In the graph below, you can see the difference between the profit/loss scenarios for both the married put strategy and the stock by itself.  As opposed to just having the underlying security, married puts limits your downside risk while still allowing unlimited profits.  The maximum loss theoretically is the price of the put premium paid.  Below, you will see an exact formula for calculating risk. 

Risk = Purchase Price of Underlying - Strike Price of Put + Put Premium

Profit Potential  = Unlimited, however decreased by the put premium paid.

Breakeven (*b1) = Purchase Price of Underlying (Should be very close to Put Strike) + Put Premium Paid

Married Put Trading Example

Let's take a quick look at a married put trading example.  GDX is currently trading at nearly $21 dollars and we think it is going to be significantly higher in the next few months.  However, assume that we also believe that here is downside risk over the next few weeks.  Therefore, we will buy GDX at $20.95 and also buy the December 21 puts, which expire in 6 weeks.  We are now in at $24.05 ($20.95 + $3.10) with a downside risk of 21.  Before we go further, let me just say that this premium is absurd, basically 15% for 6 weeks of protection.  Yes, the market is currently in the worst decline in decades and yes that means that implied volatility is extremely high; but this setup is not ideal. 

With this setup, we are looking at a breakeven price of $24.05 as we stated above.  The risk in the trade is $3.05 and the upside potential is unlimited past $24.05.

Married puts are best used when there is a higher chance of the unexpected; this could be a result of earnings announcements or other major market moving news releases.  It is very important that you do not overpay for the option, usually pay no more than 5% to 10% for downside protection at the money when you are dealing with shorter dated options.

When the markets are extremely volatile and some issues have been taken down 80 to 90% off their peaks, married puts could be justified as a way to enter the stock with limited risk; and strong upside potential.