Vertical Spreads: The Underlying


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The previous post discussed five dimensions we can use to shape a vertical spread to fit our needs. Today’s post focuses on the features of the underlying issue that will increase the likelihood that our trade will be profitable.

  • Liquidity, which is indicated by tight bid-ask spreads for the underlying as well as for its option contracts. High volume for the shares of the underlying as well as high open interest in the option contracts we deem appropriate for our trade.
  • Apparent areas of support and resistance that suggest price levels within a range that will make our trade profitable. See an earlier post for an extended discussion.
  • Decreasing Volatility, which will compliment the time decay that will profit our trade. Many posts have addressed volatility. Use the search tool to find them.

Here are some rules of thumb I use:

  • Bid-ask spreads should be different by less than 10%. Ideal open interest in in the 100s, but at least 5 or 10 times the number of contracts you want to open.
  • Break even points should be greater than resistance or less than support levels.
  • Look for issues that have an IV percentile above 60 and implied volatility greater than historical volatility.

Cautions. Be wary of opening trades over earnings reports. Consider how the underlying might respond to late breaking news that the market hasn’t had time to adjust to.

Key take-away: Of the thousands of equities and funds that are traded, most will be inappropriate for our purposes. Choose wisely.

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