Vertical spreads can have various names. The same vertical
spread could be called several different things by several
different people. We have used two terms only: vertical call
spread and vertical put spread. Each of these two spreads allows
for two positions, long and short.
The long vertical call spread is constructed by buying one call
option with a lower strike price while simultaneously selling
another call option in the same month with a higher strike
price. In a one to one ratio this trade, the long vertical call
spread, is labeled a bullish trade. This means that when
engaging into a long vertical call spread, the investor expects
the stock to increase in value. An investor who engages in a
trade with the expectation of the stock going up is said to be
bullish. Thus, a long vertical call spread is a bullish trade.
For example, you are long a vertical call spread if you buy 10
August 35 calls and sell 10 August 40 calls. The proper way to
describe this would be \long the August 35 - 40 call spread.\
Using our previous example of the August 35 - 40 call spread, we
assume that you bought the spread for $2.80. At expiration, you
know that you can lose a maximum of $2.80 if the stock closes at
$35.00 or below. At expiration, you will gain your maximum
profit if the stock is $40.00 or over. Your maximum profit is
defined as the difference between the two strikes minus the
amount you paid for the spread.
Vertical spread\'s maximum profit = (difference between the two
strikes) - (amount paid for spread).
In this case, the difference between the two strikes equals
$5.00. That $5.00 minus the $2.80 you spent on the spread leaves
you with a maximum potential gain of $2.20, and represents a
78.5% return. The potential maximum loss is $2.80 or the full
value of the investment.
The chart below shows what this spread will do over the course
of a range of stock values.
A short vertical call spread is constructed by selling a call
with a lower strike price, while simultaneously buying a call in
the same month with a higher strike price. Since owning a
vertical call spread created a long position for the owner, then
the seller of the vertical call spread must be short. An
investor who takes a short position anticipates a decrease in
the price of a stock and is considered to be bearish on the
stock. Thus, a short vertical call spread is considered a
bearish position.
Using our example, say you are short 10 August 35 calls and long
10 August 40 calls. The short vertical spread is set up in the
proper ratio and in the same month. For the sale of the spread
you received $2.80. Your maximum potential gain is the $2.80
that you received from the sale and would be obtained if the
stock closed $35 or below.
The maximum loss is calculated by taking the difference between
the two strikes and subtracting the sales price of the spread
from it. The difference between the two strikes is $5.00
(40-35). From that we subtract the price of the spread which is
$2.80 and we are left with $2.20. This $2.20 is the maximum
potential loss for a seller of this spread. The formula is given
as: The difference between the two strikes - the price of the
spread = total potential maximum loss.
The maximum profit for the seller of a vertical call spread is
attained when the price of the stock closes at or below the
lower priced strike. And the maximum loss is attained when the
stock closes at the higher strike.
The vertical put spread functions in much the same way as the
vertical call spread just in the opposite direction. Like the
vertical call spread, the construction of the vertical put is
done in a one to one ratio. The vertical put spread is
constructed by purchasing one put and simultaneously selling
another put in the same month but in a different strike.
A long vertical put spread is considered to be a bearish trade.
This means that the purchaser of a vertical put spread is
expecting the stock to go down. Further, a long vertical put
spread is considered a debit spread which simply means that the
purchaser had to put out money to buy the spread. Now, if the
stock proceeds down, the spread\'s value will expand. As stated
before, a spreads maximum value is equivalent to the difference
between the strikes. On the other hand a spreads minimum value
is $0.
In the case of a put spread, maximum value is attained when the
stock trades at or below the lower strike. Conversely, a put
spread\'s minimum value is attained when the stock trades to the
higher strike.
For example, suppose we purchase the August 50-55 put spread for
$3.00. To set up this trade, we would have bought the August 55
put and sold the August 50 put. If the stock trades down to 50
or below at expiration, the spread will be worth its maximum
value of $5.00 (difference between the two strikes: 55-50).
Since you bought the spread for $3.00 and it is now worth $5.00,
you have a $2.00 profit which represents a 66.6% profit on your
$3.00 investment.
On the downside, the most you can lose is the $3.00 you spent
for the spread and this will happen if the stock closes $55 or
above. If the stock was to close at $55, the August 55 put would
be worthless because it would be equal to the stock price thus
valueless. The August 50 put would also be worthless being that
it is $5.00 out-of-the-money. The difference between these two
values would obviously be $0. Below, the chart shows the value
of the spread at different stock prices.
A short vertical put spread is constructed by purchasing a put
with a lower strike price while simultaneously selling a put
with a higher strike in the same stock in the same month and in
a one to one ration. For example buying one Feb 65 put while
selling one Feb 70 put or buying 10 May 20 put while selling 10
May 30 put. It is considered to be a bullish trade because the
seller expects the stock to go up or increase in value. Further,
it is considered a credit spread meaning that you receive cash
into your account upon execution of the trade.
Say you were to sell the June 50 - 60 put spread for $5.50. As
the seller, your maximum profit will be the $5.50 you received
for the sale of the spread. The maximum profit will be attained
if the stock closes at $60.00 or above. At that level, both the
June 50 and 60 puts will be worthless because both will be
out-of-the-money. Thus, the spread will have no value.
The maximum loss of the trade will be defined by the difference
between the two strikes minus the amount you received from the
sale of the spread. In this case, the difference between the
strikes is $10.00 (60 strike - 50 strike). The spread was sold
for $5.50 so $4.50 is the maximum loss of the position to the
seller.
In conclusion, vertical spreads provide the buyer and the seller
an excellent percentage return while, at the same time, provide
limited loss scenarios. Vertical spreads allow for two types of
bullish trades, the purchase of a vertical call spread or the
sale of a vertical put spread. On the other hand, vertical
spreads offer two bearish trades; the purchase of a vertical put
spread and the sale of a vertical call spread.
So, if you want to take advantage of a directional stock
movement (either up or down) but you are not interested in
taking a longer term, possibly capital intensive position, then
look to using the vertical spread due to its favorable risk
reward scenario.
////////////////////////
Amazing Options Trading Strategies For Safer Investing
and Explosive Profits. Discover how to protect your
investments with the leveraged power of options. Step
by step video tutorials show you how. Click here now:
http://www.options-university.com
////////////////////////
Article Source: http://EzineArticles.com/?expert=RonIanieri
No comments:
Post a Comment