The Right Way To Buy Options - Long Vertical Spread

most option traders start out buying options because it's simple as to understand if you think Facebook stock will go up you could buy a call and if you think Facebook stock will go down you could buy put this sounds great because you can trade the options with much less capital than if you were to simply trade the stock let me show you an example first let's look at an option chain on stock XYZ which is currently trading at $75 per share let's say you are bullish on the stock and you're looking to buy a call option so we're just going to go ahead and ignore the put options for now if you were to buy the 70 strike call option for example this would cost you 750 dollars and you're hoping that the price of XYZ will rise so you can make money but this is not a very good trading strategy because it puts time decay against you and not only does the price of XYZ you have to move up it has to move up a significant amount for you to even break even in this case your breakeven is at 7750 a full two and a half points above the current stock price and if XYZ sits still and trades sideways you're screwed because your option you just bought will decay each and every day and that's what options are guys they are depreciating assets and any smart investor is not going to buy a depreciating asset and call it an investment let me show you a better way that allows you to make a directional bet on the stock but without having to buy a naked option or put up tons of capital to trade the stock itself and we're actually going to eliminate time decay altogether instead of just buying the 70 strike call option we're going to do something a little bit different we're going to buy this option but we're also going to simultaneously sell a cheaper out of the money option to reduce our cost so in this case we're going to buy the 70 strike call for $750 but we're also going to sell the 80 strike call for 250 dollars this knocks our cost down by a full $250 and our net price is now just $500 this is called buying a vertical spread by trading a vertical spread rather than simply buying a single option we're able to significantly reduce the cost of our trade which improves our breakeven on the trade and our probability of success the net price we pay for this vertical spread is five dollars so our breakeven is at seventy-five dollars per share which is where the current stock price is if you're lost hang with me I'm going to show you how this works let's compare the two strategies in three different scenarios scenario number one XYZ stock price has moved up and at the expiration date it's at $79 and 50 cents per share first let's look at the 7080 vertical spread the short eighty call that you sold for 250 would now be worthless because it's out of the money so you made $250 on the short ad call and the long 70 call you bought for 750 is now $9.50 in the money so it's worth $9.50 so you made $200 on the long 70 call so your net profit is four hundred and fifty dollars now remember the net price we paid for the vertical spread was five hundred dollars so our return on capital was ninety percent our max risk was simply the net price we bought the spread for which was five hundred dollars now let's compare this to if we simply bought the 70 call for seven dollars and fifty cents with the stock at seventy nine fifty our long call would be at nine fifty providing us with a profit of two hundred dollars so our return on capital was only twenty six point six seven percent our max risk was seven hundred fifty dollars we paid to buy this option let's look at scenario two X Y Z has mostly traded sideways and at the expiration date the price is still at seventy-five dollars per share looking at the vertical spread our long 70 call will now be worth five dollars resulting in a loss of $250 on that leg of the trade but our short eighty call will again be worthless resulting in a profit of 250 on that leg so the two cancel out and we would actually just be at breakeven on the trade now compare that to if we simply bought the 70 call at 750 we would now be sitting on a two hundred and fifty dollar loss so in the case of the vertical spread time decay was not an issue whatsoever however if you just bought the 70 call rather than trading the vertical spread you're sitting on a 33 percent loss due to time decay okay scenario three we are completely wrong about the direction of XYZ and the stock tanks down to $50 per share both of the options that make up our vertical spread are out of the money and are worthless so we lost 750 on the long 70 call but we made 250 on the short ad call so our net loss is $500 much less than losing 750 dollars like we would have if we were to simply buy the 70 strike call buying the vertical was better than buying the naked option in all three of these scenarios but there is one scenario we're buying the naked call would have worked out better let's say the stock rips higher and is now at $85 per share at the expiration date for the vertical the 70 call we bought for 750 would now be worth 15 providing us with a profit of 750 dollars on that leg and the short 80 call we sold at 250 would now be worth 5 resulting in a loss of $250 on this leg of the trade so our net profit is only $500 as opposed to $750 if we would have just bought the call so that's the only downfall with the vertical spread is that it has limited profit potential whereas buying the naked option allows us unlimited profit potential but is the profit potential really unlimited of course not that's just theoretical because theoretically a stock can go to infinity but look you still made a hundred percent return on capital on the vertical spread so what is there to be upset about and trust me these three scenarios are going to happen way more often and the vertical spread will pay far more in the long run than the few times you might eventually hit a homerun with buying The Naked option now let me show you how to pull up in order to buy a vertical spread in the thinkorswim trading platform all you're going to do is go to the option chain right click the option you want to buy then click buy vertical from there all you have to do is adjust your strike selection I personally prefer to buy one strike in the money and sell one strike out of the money when trading this strategy now we can click confirm and send and view the pop-up box to see the details of the trade such as max profit max law capital required and breakeven stock price and you can also do this on the put side if you want to make a bet as the stock will go down so alright guys hope you enjoyed the video and learn from it if so be sure to click the like and subscribe button below and also check out our website and join our email list for 3 exclusive free videos and I will see you in the next video Oh you

Channel: Sky View Trading

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Keywords: Sky View Trading, SkyView, Adam Thomas, Iron Condor, Live Trade, profits, spreads, what are options, how to trade options, option pricing, options explanation, how to buy options, stock options, option strategies, Vertical Spread Option Strategy, Vertical Spread, Bull Call Spread, How To Trade a Vertical Spread, option trading basics, option time decay, Sky View Trading https://skyviewtrading.com/, https://skyviewtrading.com/, [Sky View Trading], buying options

Id: 1SVswX2V_vE

Length: 7min 11sec (431 seconds)

Published: Sat Jul 09 2016