Papale on Vertical Spreads

By Steve Papale

Is it me or does there seem to be more commercials on TV these days?  Well it’s not just me.  The other day I’m watching a show and the first commercial comes on.  Then the second.  The third.  Fourth.  Fifth.  Finally the show comes back on.  Not so fast.   It’s not the show but a short commercial for the show I am watching.  Then a few more commercials.  We have come to a place where there are so many commercials during a show that they have to have a commercial for the show that’s on in the middle of all the other commercials.  Tomorrow during the commercial break I will cut my grass and paint my front porch.

There are several strategies options traders can use to place a directional trade.  Probably the most common one is the simple vertical spread.  There are several factors that make vertical spreads attractive.  Limited risk/return profile.  Verticals have limited risk whether it’s a debit or credit spread.  The debit spread can only lose whatever the debit is and the credit spread can only lose the maximum which is the distance between strikes less the credit received.  Of course the downside is we max out our profit to either the credit received or difference between strikes less the debit paid.

It is considered a more conservative approach than some other directional strategies.  Since verticals are placed within a single expiry we don’t have to worry about horizontal skew issues.  We still have vertical skew and overall IV to watch however.  Finally what I think is the coolest thing about the verticals is the customizability.

By adjusting strikes we can change our capital commitment, delta, gamma, theta and vega.  For example we can put on a bull spread and based on our expectations or market conditions have a long or short gamma, theta or vega position.  This can be done by moving our long a short strikes of the spreads farther or closer to the at the money strike.  Remember, the strike closest to at the money has the greatest gamma, theta and vega.  So with a stock trading at $100, we can have a 100-120 bull call spread that is long gamma, short theta and long vega.  We can also set up a bull call spread with similar delta such as 85-100 that is short gamma, long theta and short vega.  For the directional trader, the different scenarios offer an array of opportunity.


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