Options trading vertical
Each spread has two legs, where one leg is buying an option, and the other leg is writing an option. This can result in the option position containing two legs , giving the trader a credit or debit. A debit spread is when putting on the trade costs money. Here is how each spread is executed:. The table below summarizes the basic features of these four spreads. Commissions are excluded for simplicity. Vertical spreads are used for two main reasons:.
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Option premiums can be quite expensive when overall market volatility is elevated, or when a specific stock's implied volatility is high. While a vertical spread caps the maximum gain that can be made from an option position, when compared to the profit potential of a stand-alone call or put, it also substantially reduces the position's cost.
Such spreads can thus be easily used during periods of elevated volatility, since the volatility on one leg of the spread will offset volatility on the other leg.
Bear Vertical Spreads
As far as credit spreads are concerned, they can greatly reduce the risk of writing options, since option writers take on significant risk to pocket a relatively small amount of option premium. One disastrous trade can wipe out positive results from many successful option trades. In fact, option writers are occasionally disparagingly referred to as individuals who stoop to collect pennies on the railway track. They happily do so—until a train comes along and runs them over.
Writing naked or uncovered calls is among the riskiest option strategies, since the potential loss if the trade goes awry is theoretically unlimited. Writing puts is comparatively less risky, but an aggressive trader who has written puts on numerous stocks would be stuck with a large number of pricey stocks in a sudden market crash. Credit spreads mitigate this risk, although the cost of this risk mitigation is a lower amount of option premium.
Consider using a bull call spread when calls are expensive due to elevated volatility and you expect moderate upside rather than huge gains. This scenario is typically seen in the latter stages of a bull market, when stocks are nearing a peak and gains are harder to achieve.
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A bull call spread can also be effective for a stock that has great long-term potential, but has elevated volatility due to a recent plunge. Consider using a bear call spread when volatility is high and when a modest downside is expected. This scenario is typically seen in the final stages of a bear market or correction when stocks are nearing a trough, but volatility is still elevated because pessimism reigns supreme. Consider using a bull put spread to earn premium income in sideways to marginally higher markets, or to buy stocks at reduced prices when markets are choppy.
Buying stocks at reduced prices is possible because the written put may be exercised to buy the stock at the strike price, but because a credit was received this reduces the cost of buying the shares compared to if the shares were bought at the strike price directly. This strategy is especially appropriate to accumulate high-quality stocks at cheap prices when there is a sudden bout of volatility but the underlying trend is still upward.
Consider using a bear put spread when a moderate to significant downside is expected in a stock or index, and volatility is rising.
Basic Vertical Option Spreads
Bear put spreads can also be considered during periods of low volatility to reduce the dollar amounts of premiums paid, like to hedge long positions after a strong bull market. Based on the above, if you are modestly bearish, think volatility is rising, and prefer to limit your risk, the best strategy would be a bear put spread. Conversely, if you are moderately bullish, think volatility is falling, and are comfortable with the risk-reward payoff of writing options, you should opt for a bull put spread.
I've added a Fibonacci table to the chart to identify the potential upside targets for Minor wave C. So, let's move ahead. Figure 21 I've labeled the ensuing price action Minor wave B. We've also gapped up, which could be the start of wave C. But, we need to be certain. There are a couple of guidelines we can use here to lead us forward. First, Minor waves A and B look to be forming a zigzag; this is a simple three-wave pattern labeled a-b-c in which the subdivisions are And, in a zigzag, the most common relationship for wave C is that wave C equals wave A. Another guideline is that wave C may also equal 1.
In this case, Minor wave C equals Minor wave A at 2, Minor wave C equals 1. So, we will eliminate the higher Fibonacci retracement level of. Figure 22 Based on our analysis, we're going to do a bull call ladder on April 16, Remember that I am using "closing" option prices specifically. On April 16, the futures price closed at 1, So, we're going to buy a slightly in-the-money June call at 84 points. We're going to sell an out-of-the-money June call at This is where we expect wave 2 to end. The June contract expires on June 20, As you can see in Figure 22, there is also a short out-of-the-money June call at 11 points.
Creating an optimum vertical spread
The purpose of this second short call is to produce more income with manageable risk. The result is a second breakeven that is beyond the. So, the goal is to get a decent amount of premium that reduces the net debit, and create a high second breakeven level that provides a cushion against that uncovered short call, in case prices go past the 2, area where we're exposed. I have a net debit of My maximum risk is still uncapped: Maximum risk on a down move is The lower breakeven is 1, The upper breakeven is 2, That breakeven is also beyond the.
Ideally, if it's a fast-moving market and prices abruptly skyrocket or plunge, I would call my broker to exit at 2, or unwind at 1, But, if he can't get me out, I still know that after 2,, there are more points of upward movement before the market reaches 2, -- and that's just breakeven. A move below 1, Footnote: I selected these particular strikes based on the Elliott wave analysis and the market premiums that were available.
In the end, after doing several calculations, they were the best I could do for this trade. Implied volatility is Figure 23 In Figure 23, you can see that we did indeed move up in what looks like Minor wave C. And, on May 13, we hit our objective of 2, So, what do we do now? That's easy: We get out. There is no other reason to stay in this trade anymore. It's a high-risk trade, and when you read the options literature, you'll probably see a number of people who aren't in favor of this type of strategy. Assuming we can get out and it's not a fast-moving market, we close on May These are the prices: I sold the June calls at We had a net credit of The implied volatility was And we had a net profit of As always, the question remains: Did we capitalize on the opportunity at hand?
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The next chart has the answer. Figure 24 Minor wave C of Intermediate wave 2 finally peaked at 2, So, as others in the trading world might say to us, "You got lucky on that one. Figure 26 The third pair of strategies is the "ratio call spread" and the "ratio put spread" -- similar to the bull call ladder, bear put ladder pair. With a ratio call spread, you're buying an in-the-money ITM call and you're selling two out-of-the-money calls at the same strike. You may have a net credit or debit. Your market outlook is neutral to moderately bullish and short-term, about one month.
The ratio put spread has the same overall structure, but you use puts instead of calls, because you would be neutral to moderately bearish. Now, let's talk about risk. I can't stress the level of exposure here enough. However, your short strikes are closer to the money than the short strikes of the bull call ladder and bear put ladder, which had the short strikes spread out.
In other words, the out-of-the-money puts and calls are more vulnerable, and your uncapped risk is more severe. Figure 27 I'm not going to go through a trading strategy on these, but if one were to use them, it's of great value to know the "optimal" Elliott wave characteristics. Figure 27 provides a complete list of these. Function : Clearly countertrend and at the next two higher degrees, at least, because you have significant uncapped risk. In other words, not just wave two of an impulse wave.
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You would, for example, do this in a wave two of a wave three so that even the next two degrees are moving in the direction of the main trend. Since you're heavily betting on a countertrend move, this buys you more insurance against the countertrend move somehow morphing into a main trend move.
Position : Only waves two or four. Structure : Zigzag.
1x2 ratio vertical spread with calls
Degree : Relatively low. Entry Point : The latter stages of the wave position; i. Prior at the next lower degree : The same as always: An ending diagonal, truncated fifth wave, fifth-wave extension, etc. I would rely on rules only for second and fourth waves, due to the uncapped risks. Look familiar? Well, this is Figure 21 from the previous bull call ladder section. Remember that we were able to create a breakeven rate that was way up there, almost as far as wave two could go. With the ratio spreads, though, you want to get in almost near the end so that you can push the breakeven up even further to protect yourself.
Figure 29 Up next: The "bear call ladder," also known as a "short call ladder. Are you bullish? Are you bearish? You're selling an at-the-money call, but you're also buying two different out-of-the-money calls. What's going on?