Understanding the Short Vertical Spread Option Strategy

The majority of options expire worthless. When you buy an option, time is working against you because you only have a limited amount of time for the price of the underlying to move fast enough and far enough to increase the value of the option.

You could be correct in the direction of the market and still see your options lose value because the market simply did not move fast enough. To make money when buying options, you not only need the market price to move in your favor, you need it to do so with good volatility and you need it to do so long before expiration. The closer the option comes to expiration, the faster it loses value due to time erosion.

The reason why many choose to buy options is because you can only lose the amount you paid for the option. And if you get the direction right and the market moves fast enough and soon enough, you can really appreciate your investment better than had you risk the capital in the outright purchase of the underlying security.

On the flip side, due to the fact that most options turn out worthless come expiration, traders may opt to sell options instead. As a seller of the option, you get paid upfront for the value of the option in the form of premium. And since the odds favor the option losing value, many have found selling options to be quite profitable.

However, the problem with selling options is that if some event moves the market fast in favor of the option buyer, the option seller has to cover the option when exercised. The risk to the option seller is theorically unlimited. Selling options is not for the faint of heart or the inexperienced.

But what if you could have your option cake and eat it too? In other words, what if you could still get paid a credit upfront for putting on an option trade and benefit from time erosion, just like an option seller, but with limited defined risk?

Introducing the Short Vertical Spread Strategy.

Building this spread is done by using either two call options or two put options.

One of the options is sold and the other is bought. To make this spread provide a credit, the sold option will be the option with the strike price that is closer to the current price, while the purchased option will have strike price that is farther away. Because the option with the strike closer to the current price will be more valuable than the one farther away, you will receive more premium for the one you sold than what you had to pay for the one you bought.

Deciding on whether to use two puts or two calls will depend on whether you are mildly bullish or mildly bearish, respectively.

Suppose that you are mildly bullish. Suppose also that the current price of the underlying security is at $30. The $25 put option has a value of $1.60 and the value of the $22.50 put option has a value of $0.95. If you sell the 25 put for a credit of $1.60 and buy the 22.5 put option for $.95, you will end up with a total credit of $.65.

In this example, the most that you can make on this trade is $.65 while the most you can lose is $1.85 ($25 – $22.5 difference in strike price = 2.5) – $.65 you received in premium upfront.

For stock options where each contract represents 100 shares, you would be risking $185 to make $65. Now you may think that risking $185 to make $65 is not good risk/reward, but you really need to look at it this way. If the trade works out, you would then be making 35% on your investment. Now that’s not too shabby!

There is more that you must understand about this spread. Suppose that you are mildly bearish and have sold and bought a call option to put on this spread. If price rises above the strike of the call option you sold but not the one you bought, the buyer of that option could exercise it and you would be required to provide the buyer with the shares. If you don’t already own the stock, you will end up being short 100 shares of stock.

If this happens to you, simply buy to cover your short position. You can contact your broker for assistance on how to best handle this. If price moves beyond the strike of both options, your broker will handle it. Your account will simply be deducted the amount of loss as mentioned above.

There is much more you should learn before trading this strategy. For example, how to exit prior to expiration if there is a chance that price may be moving through the strike price before expiration, allowing you to possibly keep most or some of the credit depending on the volatility of the market.

With a short vertical spread (a.k.a. credit spread), time is your greatest ally. And if the market moves in your favored direction, or very little against you, you come out ahead. When you can make money with limited risk for being even a tad bit wrong in what you expect the market to do, it is certainly a strategy worth learning.

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