y: Michael Tibbits, YouCanTrade

Trading vertical spreads allows one to trade directionally with generally limited risk and limited reward. Vertical spreads are built by buying one type of option, such as a call or put, and selling that same kind of option at the same time. Both options that make up the spread are known as “legs” and will expire on the same day but will have different strike prices. For this blog, I have chosen to use debit spreads (opposed to credit spreads) for my scenarios, however, these concepts can still apply to either type of spread. It’s just easier to explain spreads when using a buying scenario (debit) rather than selling short (credit).

Oh, I almost forgot… option spread trading, for the most part, requires a margin account and broker permission. So, if you have a cash account, you’re going to be limited to “European Style” option spreads and that’s if your broker allows you permission to trade option spreads. OK… now that’s out of the way, read on!

So, why do spreads?
Sometimes, you want to make a directional trade but buying the options are too expensive and cost more than you want to risk on one trade. By trading a vertical spread, you cap some of that risk to something that is more manageable.

Legging In
One way to enter a vertical spread position is by legging into the trade – however, knowing how and when to “leg in” to a spread from a single options position can also be a useful strategy in any trader’s arsenal.

Let’s go over a few scenarios where legging into a vertical spread is beneficial.

Scenario 1: You are risking too much on a trade

Let’s say you have a $5000 account, and you bought a call that costs $1000, that trade is risking 20% of your entire account. Yikes. Although you feel good about your trade assumption and the direction of the stock, you don’t feel comfortable risking so much but you’re already in the trade. What you can do is leg into a call debit spread. To do this Buy a near-the-money Call and then sell another Call one or two strikes further out- of-the-money. By legging into a call debit spread, you lower your initial investment costs by the amount of credit you collect. The tradeoff is that your profit is capped to difference between the two strikes, minus your net cost for the spread. You will still be able to participate in some gains if the stock continues to move up, but just know that it wouldn’t be as much as holding a long call position by itself since the short call will become more expensive to buy back as well.

Scenario 2: When you cannot complete another day trade.

It’s happened to everyone. You are ready to close an options trade for a profit but there is only one problem, if you close out of the trade, it will count as a pattern day trade and you’re already reached the maximum number of day trades allowed for the week(4-trades). If you close out of this trade, your account will be flagged as a Pattern Day Trading account but you are worried that if you don’t take the profit, the position will start to lose value, or worse, turn into a losing trade tomorrow.

Not to worry, as long as your broker allows you to continue to open new positions, you can leg into a debit spread by selling the option that is further out of the money than the option you bought.

Let’s say you are up $80 dollars on a XYZ 50 put that cost you $160 to buy. At this point, all of the put strikes have gone up in value since the time you entered this position. This means that XYZ 45 strike puts that were trading for $130 are now trading roughly around $190. You can leg into a spread by selling the 45 strike Put and collect $190, locking in $30.00 in profit, and you can hold both positions until you close them out.

This allows you to maintain some of the profits you made on the long put because if the next day the stock goes up, both puts will start to lose value. However, most of what you lose long on the long put will be made up by what you gain on the short put. So, rather than worrying about having to choose between taking a day trade or missing out on taking a quick profits you can leg into a spread and use it to act as a buffer to help maintain some of the unrealized profits from a long option position.

Now let’s go over legging out

Legging out is essentially removing one of the legs of an option spread resulting in a single options position. Below are a few reasons why traders do this.

Scenario 1: To benefit from draw down

If it’s one thing I have learned, I am terrible at timing my entry on directional trades. Sure, I have indicators that help me confirm my trade assumption… but more often than not, I will enter a directional long trade, and soon after I establish my position, the stock moves in the opposite direction of my option trade. This is when the waiting game begins, as I watch my option trade slowly and painfully remain in a negative position. I start to wonder when (and sometimes if) the option will come back into a profitable position. This period of unrealized loss is called a draw down… and it sucks. Literally, time is ticking and it’s sucking value out of your option.

If this sounds all too familiar, consider setting up a debit spread. Spreads mitigate risk during draw down because the short leg of the spread acts as a hedge and becomes cheaper to buy back. Now, it is important to understand that legging out of the spread will leave your long option unprotected if the stock continues to move against it. However, if you maintain your assumption on the direction of the stock and are correct, then legging out of the short side of the spread while in a draw down will allow you to take in some profits early.

Another benefit of legging out during a draw down is that it effectively lowers your cost on the long trade. Meaning the long position may not need to climb back as much from the draw down to break even or result in a net profit. Even if you close out of the long leg at a loss, if the loss is less then the profit taken in from the short leg, you are still making a net profit.

Scenario 2: Sometimes it’s better than buying a straddle

Some of you more experienced traders reading this might be thinking. “If you have a directional bias, but know you are not good at timing your long entry, why not just buy a straddle and close out the side that profits from the draw down?”

It’s a good question. But I also have a good answer: Spreads are cheaper.

Options are not bought with margin, despite being leveraged assets, they are bought with cash. So buying a straddle (buying a call and put at the same strike and expiration) would take up nearly double the buying power than buying a single option… sometimes even a little more because usually puts option prices are skewed to be little more expensive than call options are. Straddles would be more suitable for a direction neutral trade where the stock is expected to make a very big move or in anticipation of volatility increasing. Another reason why a spread is more favorable in a draw down situation is because of time decay. The short side of the spread will benefit as time erodes the option premium, which helps to offset the negative effects of time on the long side. In the case of the straddle, both sides are long and will be negatively affected by time decay.

Disclaimer:  The author is not a financial advisor and the following should not be taken as financial advice.  This is by no means a complete discussion of the pros and cons of trading and/or investing. Please consult your own qualified advisors to determine what is appropriate and best suited to your specific investment objectives and risk tolerance.