When youíre trading options,
especially if youíre a beginner, you may lean toward single options
strategies like long calls or short puts because you only have to manage one option.
But these strategies have some drawbacks. With long calls you have to correctly predict
short-term stock behavior, which isnít easy. Naked puts carry substantial risk, and cash-secured
puts can tie up a lot of cash in your account. These drawbacks are why some strategies combine
multiple options contracts. These are called spreads, and theyíre popular because they
allow you to define your risk and reward. There are many ways to combine options into
spreads based on your goals and risk tolerance. Weíre going to focus on one of the most common:
the bull put spread, or as we like to call it, the short put vertical. This bullish
strategy is known by several different names, such as a credit put spread or short put spread,
but itís a basic concept: You sell one put to potentially profit from a stock going up, but
also buy another put at a different strike, which provides protection in case it doesnít. This
allows you to define your risk and your reward. Iím Education Coach Cameron May, and Iíve been
teaching traders about options for 15 years. Combining multiple options together
in one trade can seem complicated, but weíre going to walk through all the ins and outs.
Weíll break down how the short put vertical works and how to set it up on thinkorswim
Web, our browser-based trading platform. Itís got a lot of the powerful options
trading tools of thinkorswim desktop but in a simplified interface you can access
just by going to trade.thinkorswim.com. Weíll assume you already know the basics
of options trading and the greeks. If youíre an absolute beginner, check out our other
videos to get your bearings on options basics. So. Short put verticals. This is
a bullish strategy that involves simultaneously selling an out-of-the-money
put and buying another put with the same expiration thatís further out of the money. The
short put is the driver of the trade. It benefits from time decay and when the underlying stock
goes up, while the long put hedges your risk. Youíll have to pay the premium for the
long put, but that part of the trade is usually cheaper than the short put, so youíll
wind up with a net credit from the get-go. Keep in mind, youíll still have to pay transaction
costs. The ideal outcome is for the stock to stay above the short put so both options expire out
of the money. That way you keep the premium you received when you entered the trade.
If things donít go your way and your short put is assigned, you can exercise the
long put to deliver on your obligation to sell the underlying stock at the strike price.
Itís also possible the stock could end up between the strikes. This can be a tricky situation,
and weíll walk through ways to handle it later. But now that youíre familiar with the
basic mechanics of the short put vertical, why should you consider this
strategy? Consider risk versus return. As long as you play your strikes right, thereís a
relatively high probability of being profitable. Letís look at the strategyís risk
profile to see how this works. This is the risk profile of a short put. This will
be your main profit driver. In order for it to be profitable, the underlying needs to stay above
the break-even point, which is the strike price minus the premium. If it drops below the strike
price, you run the risk of getting assigned. Compare that to the risk profile of a long put,
your hedge. You can see the risk is defined. Put them together and you can see both the max
loss and max gain are capped. This is what I mean when I call this a defined risk and reward
strategy. Youíre basically capping your potential gains in return for defining your maximum loss.
This strategy can offer a higher probability of success than other bullish strategies like long
calls because unlike bullish single options Strategies the underlying stock can go up a lot,
it can go up a little, it can go sideways, or it can even go down a little, and the trade can still
be profitable. This offers a lot of flexibility, letting you manage how much profit youíre willing
to trade for what probability of success you want. There is a trade-off that comes with
that higher probability of success: You limit your potential profit.
To get a sense of how these really work together, letís look at an example. Letís say youíre bullish
on stock XYZ, and itís currently trading at $99. You think itís going to hold steady or move
up slightly, so you sell a put 40 days from expiration at the 97 strike for $1.50 premium, or
$150 for the contract, and you buy another put on the same expiration further out of the money at
the 95 strike for $60 per contract. With these two options combined, your net credit for the spread
is $90, (or $150 minus $60), minus transaction costs. Letís say youíre right, and the stock does
increase slightly, up to $101 near expiration. A bullish move is the best-case scenario here.
Both options would expire out of the money, leaving you with your $90 credit, minus
commissions and fees. Weíll talk about how to manage a trade like this a little later on.
But what if the flipside happens, and the stock moves down instead? Letís say the stock drops and
is trading at $93 at expiration. If that happens, your short put is assigned, meaning youíd
have to buy 100 shares of the underlying. But you bought that long put for exactly this
possibility. Because you bought the long put for a lower strike price, youíll only be
out the distance between the two strikes. Letís break that down by the numbers. Your short
put would cost you $9,700 to buy the 100 shares, but the 95 long put would let you sell the
shares for $9,500, leaving you with a $200 loss. Remember, you sold this spread for a net credit
of $90, so that would offset this a little for a total loss of $110 plus transaction costs. No
matter how much the stock drops it could drop down to $50 per share or lower that $110
is the most youíll lose on this spread. But what happens if the stock winds up
somewhere in between your two strikes? Youíll have an in-the-money short
put and an out-of-the-money long put. Depending on factors like the stock price and
how you decide to exit the trade, the trade could ultimately still be profitable, but it might not
be. Whatís most important is that youíre at risk of being assigned stock because of the short put.
If the stock does end up between the strikes, youíve got a couple choices. You could let the
trade expire and get assigned 100 shares of stock. But because your goal is not to enter a stock
position, youíll probably want to take some action, like closing the trade. Consider closing
both the long and short puts. While the short put is the one with assignment risk, closing
the long put at the same time can lock in any remaining premium in the long put, which
could help offset a loss on the short put. Keep in mind, both of these
would incur transaction costs. Now that youíre familiar with potential outcomes
of a short put vertical, letís take a quick look at what forces impact the value of the
options. These are price, time, and volatility. The first force is price and is measured by
delta. Short put verticals are delta positive, which means premiums fall as the stock
price goes up. As the option seller, you want this to expire worthless. This
greek will give you a sense of how much the options contract price may change with
a $1 move in the price of the underlying. The next force is time. Theta measures the
impact of time decay on short put verticals. Because the driver of this trade is a short
put that you want to expire worthless, itís theta positive. Remember, the max
gain for this strategy is the premium you collected when you first placed the trade.
The last force is volatility. Vega tells you how rising or falling implied volatility could
impact your options trade. Short put verticals have negative vega, so, ideally, youíd
like to see volatility hold steady or fall. This makes sense because your ideal outcome is for
both options to lose value and expire worthless. Now that youíve got the basics,
letís make some paper trades. Iíll log in to thinkorswim Web. Here you
can see all the accounts and positions, and that Iím in paperMoney, which allows me to
place simulated trades without risking real money. Iím going to close this sidebar
to give us some more room. Ok, so our first step is to choose an underlying
asset we want to trade. For this strategy, we donít need to own the stock, but we do want
to make sure itís following some entry rules. Because this is a bullish strategy, consider
highly liquid assets that are already in an uptrend. Of course, thereís no guarantee that
the upward trend will continue, but it could increase your probability of success. You could
set up a watchlist of stocks to keep an eye on. Next, weíve got to determine
when to actually enter the trade. Technical analysis can help. A chart pattern like
a bounce off a price floor or a break through a price ceiling could be a signal that a stock
is potentially ready to make an upward move. For today weíll use Expedia, symbol EXPE, as
an example. Hereís its 6 month daily chart. You can see itís in an upward trend. Let me
draw a trendline here to show what I mean. You can see there was a recent
price ceiling around 145. Iíll draw another trendline here, so we can
see that itís broken through that ceiling. So, we know what stock we want to trade, now
weíve got to choose our options contracts. To do that Iíll scroll up
and open the option chain. Up first is selecting an expiration. For a short
put vertical, the goal is to hold it to expiration and stay out of the money. There is a trade-off
at play here: We could choose an expiration thatís closer, which would mean faster time decay but
less premium overall. Further out could provide more premium but slower time decay. For a good
balance, Iíll aim for an expiration thatís 15 to 50 days out. So, in this case, weíll go with
the March 19 expiration, expiring in 36 days. Next up is choosing the strikes for our short
and long puts. Again, this is a trade-off. One way you adjust the trade-off between probability
and profit is how far out of the money you go with that strategy. A common mistake is staying too
close to the at-the-money strike in pursuit of higher potential profit or going too far
out of the money for higher probability, which significantly limits profits. For our
short put, weíll look for a delta between .30 and .40. Ideally, this strike price is at or below
support levels, which could mean the stock is less likely to fall below our strike. We can see the
140 strike has .32 delta and is below support. This will give us a good shot at the option
expiring out of the money while still providing a decent amount of premium. It also looks like the
difference between the bid price and the ask price is less than 10% of the ask price, which suggests
good liquidity. So letís plan to sell that one, so Iíll click the bid price. You can see
itís entered at the bottom of the screen. Now, we need to choose the strike for our long
put. This strike should be below our short put. Thereís another tradeoff here. The width of the
spread determines how much credit weíll receive for selling it. But the wider the spread, the
more risk you open yourself up to because your max loss is the distance between the strikes. One
common rule is to choose a long put at least $2 below the short put. For us, the next available
strike is $5 away, at 135. Itís allowing us some breathing room. Iíll click the ask price.
Youíll notice our order now says vertical. Letís scroll down and look at it. So, here in
the order editor I can see Iím selling the March 19 140 and buying the March 19 135. Now youíll
notice the price of our spread is still moving. Letís lock our required credit to a limit of
165. And weíll leave the time in force at day. Now we can figure out how many spreads to
trade. To do this, you need to know two things: your portfolio risk and your trade risk. Portfolio
risk is the total amount of your portfolio youíre willing to lose on a given trade. Consider
setting aside no more than 1% of your active trading portfolio per trade. So, for simplicity,
letís say Iím trading with a $100,000 portfolio. If Iím willing to lose no more than 1%, my
portfolio risk would be $1,000 per trade. Trade risk on the other hand is the
amount you could lose in a given trade. For a short put vertical, the trade risk
is the distance between the two strikes (think short strike minus long strike) minus
the credit you received from the spread. In other words, the spread width minus the credit.
For this trade thatís a $5 wide spread, or $500 minus the anticipated credit of 1.65,
or $165, for a trade risk of $335 Now that we know our portfolio and trade risk,
we can figure out how many spreads to sell. To do this, take your portfolio risk
and divide it by your trade risk. So, our portfolio risk of a 1,000 divided by the
trade risk of $335 equals just about 3 spreads, which Iíll enter in the trade ticket.
Now that weíve got our trade loaded up, letís do some quick analysis using
a nifty feature on thinkorswim web. Below the order ticket youíll see a
stock chart and a risk profile chart. On the stock chart you can see two tabs
representing my strikes, and where they fall in relation to the stockís historical price.
You can also hover your mouse over either chart to get a sense of where a given underlying price
would fall on the other. In the risk profile, the curved dotted line represents how different
prices would impact my profit or loss today, while the green and red boxes represent
at expiration. For example, we can see our breakeven for today is approximately 150. However,
at expiration, due to the effects of time decay, itíll be about 138 and half, 138.35 to be
precise, not accounting for the transaction costs. You can see the stock being anywhere
above there at expiration would be profitable, though once we reach 140 both contracts expire
worthless and we hit max gain. In the other direction, anywhere below 135 at expiration, both
options would be in the money and Iíd hit max loss Letís go back up and place the trade. Iíll
click review and confirm the details are correct. Note the transaction fee, in this case
3.90, or .65 per contract. Now Iíll click send. Thereís the confirmation saying our orderís been
sent. Ok, weíve placed a short put vertical! But this isnít a set it and forget it kind of
strategy. Weíve got to make sure weíre keeping up with it. The way you manage these trades
can make or break them, so weíre going to walk through managing some other sample short put
verticals that Iíve got in a paperMoney account. But before we go through them, letís talk about
a simple rule that can guide how you manage your short put spreads: If youíre more than five to
10 days from expiration, manage your winners. If you have less time than that, manage your
losers. Let me explain what I mean. Set a profit Target this could be something like 80% to 90%
of the max gain and then close your winners when they reach that target, even if itís just a few
days after youíve placed the trade. If you get to 10 days before expiration, start weighing
whether you should exit your losing trades. Letís open up Nvidia, symbol NVDA.
Both of our strikes are out of the money. Our original credit was
4.09, which is our maximum gain. Our current unrealized gain is around $400,
leaving us with only about $9 of remaining profit. We could let it ride and leave it open for
an extra 9 days, but that opens us up to the risk of it turning downward, and we could
lose out on some gains. Since weíve already achieved 98% of our max gain, Iím going to
close this trade to lock in that profit. To close the position Iíll click the
symbol, which opens up more details. The position is already selected, so I can click
close selected to bring up the order entry. So you can see Iím selling the long put
and buying the short put for a debit of 8 cents. Iím going to nudge that to 9 cents
to increase my likelihood of getting filled. Now Iím going to click review, where I can see the
cost of the trade, which includes $1.30 in fees. Ok, letís go back to our positions and take a
look at another one. Iíve got a spread on Union Pacific, UNP, and you can see both options are
in the money. This is looking like a likely max loss scenario, and the risk of early
assignment on my short put is elevated. But Iíll give it one more day in hopes itíll
turn around and I can avoid max loss. Remember, if both options were to expire in the money, my
long put would help cap the loss on the short put. In any event Iíll close it tomorrow, whether
weíre further from max loss or closer to it, in order to salvage any remaining
value before expiration. Alright, letís look at one more sample trade to
answer the question, What happens if the stock lands between my strikes? So, on Pepsi you can
see I sold the Feb 12 142 put and bought the Feb 12 137. Iíve only got 2 days to expiration, and
the stock is now just above 137, so the short put is in the money, but the long put hasnít been hit
yet. Weíre facing a potentially tricky scenario. I havenít hit max loss yet, but Iím definitely
at risk of assignment on the short put and my long put is still out of the money. If we hit
expiration in this scenario, the short put will be assigned, but the long put would expire worthless,
leaving us on the hook to buy 100 shares that we never intended to own. So, to avoid assignment,
Iím going to close the position for a loss. Iíll follow the same process as my earlier
trade that was a winner: click the symbol, click close selected. Iím going to leave it at the
mid price and review the details, which show Iím buying the vertical back at a cost of $350. At
expiration it could have cost as much at $500, so Iím preventing a max loss. Note the
transaction fee of $1.30. Now Iíll click send. There you go. Thatís the nuts and
bolts of the short put vertical. Or the bull put spread. Or the you get the idea. Remember, even though the approach we
discussed may be higher probability and less risky than others youíve seen
out there, itís still risky. Make sure you practice paper trading to get a
feel for how these trades can move. Be sure to check out our coaching webcasts too.
We have lots of options education that you should take advantage of because management
is such a huge part of trading options. To try out thinkorswim Web,
visit trade.thinkorswim.com. If you want to practice, make sure
you switch to paperMoneyÆ in the top left corner to get a handle
on how vertical spreads work. You can also download the
full thinkorswimÆ software, which weíve linked to in the description. We
have a ton of other education on our channel, so make sure you subscribe and hit the bell
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