Going Vertical: The Simplest Option Spread of All

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The following article is from the spring 2009 issue of Bernie Schaeffer's SENTIMENT magazine, which is designed specifically for those interested in trading options. Every issue of SENTIMENT includes educational pieces for newcomers to options trading, as well as advanced strategy stories to help experienced traders build their portfolios. Please click here if you would like to receive your own copy of the next quarterly issue of SENTIMENT.

One of the things that I learned as a professional trader was that I didn't always have to be right to make money. I may be speculating that a stock will go up, but even if it doesn't, I can still squeeze out a profit. The way I do that is with short verticals. I put the probabilities on my side by selling an out-of-the-money put vertical if I think the stock will go up, or selling an out-of-the-money call vertical if I think the stock will go down.

In very broad terms, a stock can go up, down, or stay the same. A short out-of-the-money vertical can make money in two of those three scenarios, especially when the stock "stays the same" and doesn't move very much at all. Trading verticals turns the old rule "buy low, sell high" on its head. When I have a short vertical, I'm hoping to sell high, buy low.

A vertical option spread is made up of a short (sold) option and a long (bought) option, both either calls or puts, and both in the same expiration month. A vertical can be bullish or bearish, or have a more neutral directional bias—where the outcome is decided by what the stock doesn't do, rather than what it does do. In that sense, it is just another tool for you to use when you speculate on the direction of a stock. It lets you have a wider range of stock prices where the position can be profitable.

Vertical Mechanics

The way short verticals let me "sell high, buy low" is that they take advantage of two concepts—one absolute and one theoretical. The first (the absolute) is that time will pass. With each passing day, the expiration of options moves closer and closer. And as it does, all other things being equal, the value of options gets smaller and smaller. So, if I sell an option today and it gets cheaper tomorrow, I can profit from that. The other is that theoretically, the best estimate of where a stock will be tomorrow is right where it is today. That goes along with the Random Walk theory, in which stock prices often end up right where they started. Over the long term, stocks may trend up or down, but in the short term, they typically don't make big moves. That's what makes trading short verticals so compelling. And even if a stock does move a lot, as long as I called the direction correctly, a short vertical can still make money. For these reasons, short verticals are a cornerstone of my trading strategy. They are versatile, and the simplest option spread of all.

With short verticals, you take in a credit because you sell the strike closer to the money and buy a cheaper, further out-of-the money strike. Let's look at an example where we are bullish on that old favorite, XYZ trading at $100, and we're thinking about selling an out-of-the money put vertical. It's not complicated. It could mean selling an XYZ $95 strike put and buying an XYZ $90 put, all for, say, a $1.50 credit. The max risk of a short vertical is the distance between the strikes (in our example, $5 or 5 points) minus the credit received. If you sell a 5-point vertical for a $1.50 credit, the max risk is $350. In our XYZ trade, even if the stock goes to zero, we still only lose $350. On the other hand we also make money as long as the stock price is anywhere above $93.50 (the breakeven point) at expiration (see Figure 1). Breakeven is simply the short strike minus the credit for a short put vertical, or, adding the credit to the short call in a short call vertical.

Why puts and not calls if you think the stock is going up? It might seem counterintuitive, but that's the nature of the short vertical. If you're selling a put, you want the stock to stay above the short strike to avoid a loss. Likewise, if you're bearish and want to sell a vertical, you use calls. Our XYZ short put vertical would make money if the stock goes up, stays the same, or even drops a few points. The max profit is limited to the credit you receive—$150. Not very impressive, you say. But given the much wider range of stock prices where the position is profitable (i.e. up, sideways, or even down some), the short put vertical has a higher probability of profit than other directional strategies, such as long calls.

While a distinct advantage of a long call is its unlimited upside potential, the short put vertical benefits from just about everything that can hurt a long call, which makes it a nice alternative when the stars aren't fully aligned for your call strategy. For example:

Time passing? The short put vertical likes that because it has positive time decay, meaning time is working for you as the spread drops in value each passing day. That's good when you're short!

Volatility crush? A drop in volatility prior to expiration actually helps you as the spread you sold becomes cheaper to buy back. Also, when volatility is lower, there's less of a chance that the stock will make a big move down and create a loss on that short put spread.

Wrong direction? If the stock stays where it is or moves down a bit, the short put spread can still make money. For example, if XYZ goes up $2, the short put vertical makes $150. If XYZ goes down $2, the short put vertical makes $150. If XYZ stays right at $100, the short put vertical makes $150. See a pattern here? As long as XYZ is above the short $95 put at expiration, XYZ put vertical makes its maximum profit of $150. In fact, it makes some money as long as the stock is above the breakeven point of $93.50. And as we get closer to expiration? Well, that put spread you sold just gets cheaper and cheaper.

Vertical Recap–The Bennies and Caveats

The point of a short vertical is that you don't have to be exactly right on the direction of the stock, the magnitude of the move, or the timing of that move, assuming you're out of the money. And short verticals have certain characteristics that make them attractive. Because you're short a closer-to-the-money option, you get positive time decay. And because you're long and short an option, preferably with adjacent strikes, short verticals don't have a lot of sensitivity to changes in volatility. The way I like to think of short verticals is that I am selling an option and capturing positive time decay, but I have a hedge in the long option—which defines my risk and reduces the margin required.

Does this sound like a cool strategy? Absolutely. But it wouldn't be completely fair to let you walk away from this article without understanding some of the shortcomings of the short vertical—and there are a few. First, as mentioned, you're limited in what you can make per trade, since your upside is capped to the credit you receive. Second, at times, the margin you'll need to put up can be higher relative to a long call or put around the same strikes, which does tie up your capital somewhat (though much less so than the strategy's cousin—the short, naked put). Finally, high volatility in the absence of a trend can make it difficult to stomach wild, unpredictable swings, such as those we saw in the crash late last year. Sudden drops in the market on those 500-point down days could render your beautifully executed vertical a shell of its former self, or even a complete loss. But no strategy is perfect—just different or better in some circumstances—and the short vertical isn't the exception.

More Nuggets

A little extra tip on trading short verticals is an easy way to estimate the probability of success—just take the max risk and divide it by the distance between the strikes. So, if the max risk of a vertical is $350 and the distance between the strikes is $500, there is an approximate 70% probability (350 divided by 500) of that short vertical making money at expiration.

One more thing about short verticals is that you can trade them in IRAs, where you have to get creative if you want to speculate that a stock is going down. You can't short stock, and you can't short naked calls. You could buy a put, but that has all the same problems as a long call. So, when you find a stock that you're bearish on, some basic criteria on finding a short vertical would be to look at the options that have roughly 30 days to expiration, and then find an out-of-the money call vertical that has an approximate 70% probability of success. It's no guarantee of profitability, but you will have a better chance of making money than if you buy an out-of-the-money put.

Versatility, defined risk, and positive time decay are all reasons why professional traders make short verticals a cornerstone of their strategies. And in markets like we've been seeing lately, it's why savvy retail traders are using them, too.

While aggressive option strategies exist for traders with a high tolerance for risk, it is equally true that conservative, high-win strategies exist for investors with a lower risk tolerance. Credit spreads, as described in this article, are the chief strategy behind our popular Wealthbuilder Alert Service. This strategy, which aims for gains of 15-20% per trade, has resulted in an 80% win rate since its inception in 1993. If you like to learn more about WealthBuilder, please click here.