Vertical spreads offer an option trader a wide variety of risk/reward scenarios. As I like to say, there are options on your options. Maybe more importantly, there are trade-offs when it comes to options and the different strategies that can be used and vertical spreads are no different.
Many new option traders tend to stay away from credit spreads. When I teach new option traders, I tell them to consider keeping their contract sizes very small if they are going to trade vertical credits. If a vertical credit is set up out-of-the-money (OTM), it offers a higher probability of success. Debit spreads (depending on how they are implemented) usually offer higher rewards based on the risk amount and are often viewed as a safer and easier to understand choice. Once they understand credit spreads, many option traders prefer them over debit spreads because of the higher probability. Let’s look below at a few bearish vertical spreads and some of the points option traders need to reference.
Benefits of Credit Spreads
One of the nice things about a credit spread is option traders can profit if the underlying doesn’t move much or moves in the intended direction. A debit spread, such as a bear put spread, often needs the underlying to fall to profit from the spread.
A bear call spread involves selling a call option while purchasing a higher strike call option with the same expiration. The short call option is more expensive than the long call option. Adding a long call option to the short call position creates a credit spread and protects the position from further losses if the underlying rallies past the two strikes. This credit spread has a smaller potential profit than a naked call option but also limits risk.
Bear Call Spread in Amazon
Amazon.com Inc. (AMZN) was trading at around $143 earlier this month. After moving higher early in August, the stock has been trading sideways and unable to close above its 200-day moving average around the $143 level. A trader might assess that this resistance could be a difficult area for the stock to rise above even with this recent move lower. He or she could thus try to capitalize from this forecast by trading a bear call spread.
Here the trader would sell a call even a little higher than potential resistance at $143 and buy a higher-strike call for protection, thus creating the spread.
With a bear call spread, choosing strikes that are further away from the current price with the same strike distance usually means less credit will be received on the spread. For example, if the current stock price is $143, a 144/146 bear call spread should generate a larger credit than a 146/148 bear call spread. The credit received is the maximum profit that can be attained. So, with a bear call spread, there exists a natural trade-off of chances of success vs. payout structure. The higher the short strike, the safer; the lower, the greater profit potential.
How to Implement
In the above example, the trader decides to sell a 146/148 Aug-26 bear call spread. To do so, he or she sells the Aug-26 146 call for a credit of 1.50 and buys an Aug-26 146 call for a debit of 1.00. The total credit on the spread is 0.50. If AMZN finishes at or under $146 by Aug-26 expiration, the spread would expire worthless and the trader would keep the credit. The maximum at risk on the trade is the difference in the strike prices minus the credit received, which in this case is 1.50 (2 – 0.50). The breakeven point is $146.50 (146 + 0.50), which is derived from adding the credit to the short call.
Final Thoughts to Ponder
When choosing whether to do a bear call or a bear put, a trader also has to take into account his or her trading personality. Just because one spread may seem advantageous over another doesn’t mean it should necessarily be implemented. Some option traders cannot bear the thought of taking a maximum loss on a credit spread like the bear call and have trouble sleeping at night worrying about it. If that is not a major concern for you as a trader, remember that depending on how it is implemented a bear call spread may offer lower potential profit, but it also offers a greater chance of profiting.
John KmiecikJohn Kmiecik
Senior Options InstructorSenior Options InstructorJohn Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.