One Thing: Vertical Spreads

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I’ve written before that successful option trading has a lot of moving parts, but I’ve invested a lot of energy into learning them one at a time. My focus has been on vertical spreads. It’s been my one thing for now.

Most people refer to vertical spreads as a trading strategy. I don’t want to play the role of word policeman, but I prefer to think of verticals as a tactic that supports the strategic growth of value in one’s portfolio. For me vertical spreads are short-term transactions that are chosen and managed in a way that contributes towards the accumulation of wealth. It’s like a nutritionally balanced meal or a trip to the gym or the pre-breakfast jog or the time logged on the Peloton that promotes a lifestyle of physical and mental well-being.

First and foremost, I like vertical spreads because they define both the risk and profit one can expect from a trade. I also like them because they can return profits in any kind of market–up, down, or sideways. I really like the ability of spreads to make money even if market moves are sideways. Not to get nostalgic, but they remind me of my boyhood days on the Lake Michigan watching the waves roll up on the shore and then retreat. I see the same movement in the price charts, and seek out a level that ends in profit even if the price recedes a bit. A lot of investing involves prediction, which reminds me of the weather. A meteorologist once told me that if you predict that tomorrow’s weather will be like today’s, you’ll probably be right. So I construct vertical spreads that will win a profit even if the underlying moves a bit away from me.

Vertical spreads can be described in five binary dimensions:

1. The width of the spread, which is equal to the difference between two strikes in the spread.
2. Credit or debit, also referred to as long or short, bought or sold. When you sell a spread, you receive a credit when the trade opens. That credit equals the max profit you can receive when the trade closes. The max loss is equal to the width of the spread minus the credit when you you sell a credit spread. When you buy a spread, the debit charged to your account is the max loss that can result when the trade closes. The max profit when you buy a spread is the width of the spread minus the debit.
3. In the money (ITM) or out of the money (OTM). These are terms that are relative to the point of view of the buyer of the spread. ITM calls are at strikes below the price of the underlying. ITM puts are above the price of the underlying. If you buy a spread, you hope it ends up being ITM at expiration. If you sell a spread, you hope it ends up OTM at expiration.
4. Bullishly biased or bearishly biased. If the risk on a spread is on the downside, it is bullish. If the risk is on the upside, it is bearish. Both bullish and bearish verticals can be assembled to turn a profit if the price of the underlying varies either up or down within limits.
5. Calls or puts. Vertical spreads can be assembled from either two puts with different strikes or two calls with different strikes.

Keeping up with all these dimensions can be challenging. So I simplify my trading by assembling credit spreads that are OTM. If I’m biased bearishly, I sell an OTM call spread. If I’m bullish, I sell an OTM put spread. The two images below are of the profiles of each type of spread I favor.

Importantly, both of the trades shown above are in territory that will benefit from the passage of time. Even if the price of the underlying varies a little bit, the trade will maintain its profitability just like the mean water level of Lake Michigan remains constant as the surf rolls.

The success I’ve had with vertical spreads depends upon more than strike selection, and in following postings I’ll focus on additional factors.

Key take-away: Find your one thing.