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business newsDissecting the Vertical Spread
Credit versus debit, and how to tell them apart.
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Basic vertical spreads are the bread position for many option traders. Because it's a strategy I expect to employ in the recently launched OptionSmith on Minyanville, it would be good to discuss the 2 basic types: credit and debit.
To create a vertical spread, one buys/sells an equal number of call or put contracts in the same underlying stock, with the same expiration but different strike prices.
Before we go any further, it's important to make clear that a net credit position -- or one in which a person sells short, a greater dollar value of option premium than is purchased -- doesn't equate to having a "naked" (or "short") option position, which carries the risk of unlimited losses.
The general attraction to using spreads, is that it helps control risk. This is done in 2 basic ways: The above mentioned equal number of contracts, short and long, means the position’s maximum loss (and profit) are defined; and the simultaneous purchase and sale of similar options reduces the impact of the greeks on the option's price.
Specifically, the impact of implied volatility, or vega risk, is greatly reduced. IV and its relative vega is one of the most important, yet least predictable, greek in determining a position's value and ultimate profitability.
Anytime one can gain some control or reduce the impact over a risk variable, it will help increase the probability of a profit.
Likewise, the long/short construction of a spread also helps dampen the impact of time decay or theta. But unlike volatility, theta moves in only one direction and is easily measured. That's why all else being equal, many option traders have a natural bias for employing credit strategies that place the tailwind of time decay at their backs.
Similar But Not the Same
For every position that can be created using calls, a similar one can be established using puts. A buy-write -- which consists of buying stock and selling calls -- can be replicated through the sale of puts.
Similarly in a spread, if one is bullish on Apple (AAPL), currently trading around $85 per share, one could purchase the March $80/85 call spread for $3 net debit, or sell the March $85/80 put spread for a $3 net credit. Both have a max loss of $3 if Apple is below $80, and a max profit of $2 if Apple is above $85 at expiration.
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