The Vertical Spread Options Strategies (The ULTIMATE In-Depth Guide)

there are so many different options strategies out there that are available to you as an options trader but today's video is incredibly important because we will be focusing on arguably the four most powerful options trading strategies that you can trade as an options trader and let me just tell you if you can master your understanding of these four vertical spread strategies today you will make a massive leap forward in your options trading expertise and knowledge and that's because if you understand these four vertical spread strategies you will essentially understand eighty percent of the option strategies in existence specifically i'm going to teach you these four strategies using numerous examples and trade performance illustrations so that you can fully understand how these strategies perform relative to changes in the stock price and the passage of time before we get started i should note that there are prerequisites for this video this is considered at least in my opinion the second installment of my options trading for beginners ultimate guide and i'm going to assume in this video that you have an understanding of how buying call options and put options works how shorting call options and put options works and i will also be assuming that you understand what intrinsic and extrinsic value are without further ado let's get started so today's video is all about vertical spreads but what exactly is a vertical spread a vertical spread is the combination of two options trades that are placed simultaneously the first trade is purchasing a call or put option at a strike price and then the second component of a vertical spread is shorting another caller put option at a different strike price now you'll be using either calls or puts as a quick example of a vertical spread let's look at a vertical spread setup in apple in this image we can see a call vertical spread that i've queued up in apple by purchasing the 140 call option and shorting the 150 call option this is an example of a vertical spread because i am purchasing a call option at one strike price and shorting another call option at a higher strike price now this is called a vertical spread because you're trading two different options at different strike prices within the same expiration and the strike prices are listed vertically on the option chain so you're basically creating a spread vertically when you're looking at it on the option chain at least that's how i interpret it but why would somebody want to trade this vertical spread as opposed to simply purchasing that 140 call all by itself let me go through a real quick demonstration by hopping over to my brokerage platform which is tastyworks and by the way if you are in need of a brokerage account and you're interested in tastyworks please check out the links down in the description below and you'll learn how you can get my exclusive s p 500 options trading course when you open and fund your first tastyworks account using the project option referral code and look i don't make money on this channel by having you pay me out of pocket and by using that referral code and opening a tastyworks account if you are interested it's a phenomenal way to support me in the channel and that's how i prefer to make my money through things that don't cost you anything and that actually connect you with things that are valuable to you so go ahead and check out those links in the description if you are interested so let's check out this trade right now so i'm going to look at apple and right now apple is down about seven dollars today with the stock price around 124 so let's go ahead and look at a 120 call purchase in the october expiration cycle if i wanted to buy the 120 call option in apple today it's currently listed at a price of about eleven dollars and sixty cents and with that i would have to basically put up one thousand one hundred and sixty dollars to enter this call option position but what if i didn't want to spend so much money on this call option but i still wanted to have a trade that would make money when the stock price increased and let's say i thought apple might increase to 130 over the next 43 days instead of just purchasing this 120 call option i could also short the 130 call option and by doing so i reduce the cost of my trade from around eleven hundred dollars to four hundred and thirty five dollars now this not only reduces my risk but it reduces my break-even price as well so the break-even price for this vertical spread here would be 124.35 which essentially means i only need apple to be at one 124 35 at expiration for this spread to not make or lose any money but if i were to just purchase that 120 call option for eleven dollars and forty cents then my break even price would be one thirty uh one hundred thirty dollars and forty cents so by doing a vertical spread trade you can actually reduce your risk and you can make it a higher probability trade that you can make money on because your breakeven price will be much more favorable as opposed to simply buying that call or put outright so now that we've briefly touched on what a vertical spread is and why somebody would want to trade one as opposed to simply trading an option by itself let's look at the four vertical spread strategies in depth so that you can fully understand each of these four strategies and then we'll move on to the more important and exciting topics in my opinion now i will warn you this is going to be a fairly repetitive and lengthy section of the video so by all means if you want to skip ahead because you're starting to grasp the strategies very quickly and you want to go to the more unique and exciting topics near the end of the video please feel free to do so and you can look at the playhead on the video which is sectioned out or you can go to the video description and click on the timestamps to access various sections of this video by the way if you are enjoying this video thus far and you like what you see please give this video a thumbs up and hit that like button down below and if you're new to the channel and you have no idea who i am please consider checking out some other videos on my channel and consider subscribing the first of the four vertical spread strategies we will cover today is called the bull call spread now as the name suggests the bull call spread is a bullish options trading strategy that is constructed using call options the bull call spread is constructed by purchasing a call option at one strike price and simultaneously shorting another call option at a higher strike price sometimes the bull call spread is referred to as simply buying a call spread or a call debit spread so these vertical spreads have many different names and it depends on the trader you're talking to so you'll just have to familiarize yourself with the various names of these spreads with experience so we're going to look at a real historical bull call spread and we're going to see how the trade performed over time relative to changes in the stock price so let's check out the characteristics of this bull call spread example the stock price at entry is and 28 142.28 and to construct this call spread we're going to buy the 135 call for nine dollars and 30 cents and we're going to short the 150 call for 1.54 cents both of these call options are in the 46 day expiration cycle the purchase price of this spread is 7.76 which comes from the fact that i bought the 135 call for 9.30 and shorted the 150 call for 1.54 cents bringing my net payment for this spread to 7.76 now this means i actually need 776 dollars to purchase this spread because we need to multiply that spread price by the option contract multiplier of 100 and that's something you will have learned in the options trading for beginners video the break-even price for this spread at expiration is 142.76 and that comes from the calls strike price of 135 plus the entry price of 7.76 now i just did a video explaining breakeven prices in depth so if you are unfamiliar with how break-even prices are calculated or why they make sense be sure to check out that video in the description on how to get any strategies break even price at expiration so before visualizing the performance of this trade through time let's actually look at the risk profile for this position at expiration so we can understand at expiration what the profits and losses will be for this position based on various stock price scenarios the first thing to know is that this strategy has limited risk and the most the strategy can lose as described earlier is the entry price or entry cost of 776 dollars so if i buy this spread for 7.76 and it expires worthless my loss will be 776 dollars and that will occur if the stock price is at or below 135 dollars at expiration because if the stock price is at or below 135 the 135 call and the 150 call will both expire worthless and therefore the spread itself will be worthless the break-even price of this call spread is 142.76 at expiration and that means if the stock price is at 142.76 at expiration the 135 call option will have intrinsic value of 7.76 but the short 150 call will have zero dollars of intrinsic value and therefore the net value of the spread would be 7.76 which is the same as the entry cost and therefore the position will not have a profit or loss if the stock price is exactly at 142.76 at the time of expiration and lastly the maximum profit potential of 724 dollars will occur if the stock price is at or above the upper strike price of 150 at the time of expiration and that's because the maximum value of any vertical spread at expiration is the width of the strikes and in this case the call spread has strikes that are fifteen dollars apart which means the maximum value of this call spread at expiration is fifteen dollars or a actual value of fifteen hundred dollars so if i buy this call spread for a entry cost of seven hundred and seventy six dollars and it appreciates to its maximum value of fifteen hundred dollars my profit on the trade will be seven hundred and twenty four dollars the reason that this call spread can only be worth fifteen 15 at expiration is because if the stock price is fully above the call spread meaning the stock price is at or above 150 if we take the intrinsic value of the call option that i own and subtract the intrinsic value of the option that i'm short it will always come out to 15 at expiration so for example if the stock price is at 155 at expiration the 135 call that i own will have twenty dollars of intrinsic value but the 150 call that i am short will have five dollars of intrinsic value and basically what that means is that if i want to close that spread at expiration i could sell the 135 call for twenty dollars collecting two thousand dollars in premium and i could i would have to buy back the short 150 call for five dollars therefore paying out five hundred dollars in premium and that would leave me with a net premium collection of fifteen hundred dollars at expiration so this is the expiration payoff graph which only really matters at expiration but how did this strategy actually perform as the stock price changed over time let's take a look on the top portion of this graph we have the changes in the stock price relative to the strike prices of this call spread and on the bottom portion of the graph we're looking at the actual changes in the spreads value as the stock price changed in the first few days of the trade the stock price drifted lower which caused the call spread to lose value if the spread price declines from the price you pay for it you'll have an unrealized loss fortunately we can see that the stock price rocketed higher in the subsequent weeks leading to an increase in the call spread's value you'll notice that there was a moment where the stock price was above the entire call spread but why wasn't the spreads price 15 because i know i said that the maximum value of the spread at expiration would be fifteen dollars if the stock price was above one hundred and fifty dollars well we will talk about that later in the section titled vertical spread profitability versus time to expiration at around four days to expiration the spreads price was very close to its maximum value of fifteen dollars it's worth mentioning here that you can close a vertical spread whenever you want to you don't have to hold until expiration if the maximum potential value of the spread is fifteen dollars and the spreads price gets close to fifteen dollars then it makes sense to close the trade because you have very little left to gain from holding it but you have everything to lose at the very end of the trade we can see that the stock price did dip lower and the call spread lost substantial value and that's exactly why a spread should be closed when it approaches the maximum potential value it's really not worth holding at the time of expiration the stock price was at 148.06 leaving the trade with a profit of five hundred and thirty dollars but where does this profit come from if the stock price is at one hundred and forty eight dollars and six cents at expiration the 135 call will have intrinsic value of 13.06 while the 150 call will have no intrinsic value and expire worthless therefore the value of the spread at expiration is limited to the intrinsic value of the 135 call which is thirteen dollars and six cents meaning that in actual dollar terms the spreads value would be thirteen hundred and six dollars and if i buy a spread for seven hundred and seventy six dollars and it expires with a value of one thousand three hundred and six dollars my profit is five hundred and thirty dollars so what we've learned with this example is that when you buy a call spread or you trade a bull call spread you want the stock price to increase and ideally you want the stock price to be above the upper strike price of the bull call spread at the time of expiration as that is a scenario that will result in the spread having its maximum potential value which we also learned is the distance between the strike prices so if i have a twenty dollar wide vertical spread the most it can be worth is twenty dollars if i have a one 100 wide vertical spread the most that spread can be worth at expiration is 100 so keep that in mind we also saw that as the stock price goes up and down so does the value of the call spread and this is important to understand because when you enter any option position it's not a binary event where you only get the profit or loss at the time of expiration the option prices or the options spread in this example will change every minute of the day as the stock price is changing and you can get out of that spread or option position whenever you want to so just because it has an expiration date it doesn't mean you have to hold until the expiration date so to close the call spread in this example since i bought the 135 call as an opening trade and i shorted the 150 call when i opened the trade to close this call spread i just have to sell the 135 call that i own and buy back the 150 call that i am short and you can do this in one transaction at one spread price and effectively that will realize whatever profit or loss you have on that spread at that moment so you never have to hold a spread until expiration you can close it whenever you want so i could buy a call spread and sell it five seconds later if i wanted to i can get out whenever i want to alright let's move on to the second bullish vertical spread which is called the bull put spread as the name suggests a bull put spread is a bullish vertical spread constructed with put options as opposed to call options which we just discussed to set up a bull put spread a trader will short a put option at one strike price and purchase another put option at a lower strike price now this is sometimes just referred to as selling or shorting a put spread but it is also referred to as a put credit spread because when you enter the trade you will collect a net credit meaning the option that you sell is more expensive than the option you purchase and therefore you will collect premium when you enter the trade and that's why it's called a credit spread the goal when trading a bull put spread is to see the stock price increase but at the very least the trade can make money so long as the stock price remains above the short put strike price as time passes so if the stock price is here and you sell this put spread here you can make money so long as the stock price remains above this put spread and that means it is a high probability trading strategy meaning that you have a greater than 50 percent chance in theory of making money on that trade so just like we did before let's go ahead and look at a real historical example in this example the stock price is at 146.92 at the time of entering the trade to construct this bull put spread we will short the 145 put and collect six dollars and sixty cents and simultaneously purchase the 135 put for three dollars and seven cents both options are in the 46 day expiration cycle the entry price for this spread is 3.53 that is received since i shorted the 145 put and collected 6.60 and paid seven cents to buy the 135 put so a net premium is collected at entry the break even price for this particular position is 141.47 and that means if the stock price is at 141.47 at the time of expiration then this put spread will not make or lose any money so remember earlier i said that the maximum value of a vertical spread is the distance between the strike prices and in this case since the put strikes are 10 apart the maximum value of this put spread at expiration is 10 so let's look at the expiration payoff diagram for this particular bullet put spread position so as we can see here the best case scenario is that the stock price is above the entire put spread at expiration if the stock price is above 145 dollars at expiration the 145 put and the 135 put will have no intrinsic value and therefore will expire worthless leaving the spread with a value of zero dollars if i collect three hundred and fifty three dollars for this spreaded entry and the spreads price falls to zero i will effectively make 100 of the profit potential or 353 dollars and so when you short a put spread like this you want all of the options to expire worthless which will happen if the stock price increases and is above both put spreads strike prices at the time of expiration the expiration break even price of this position is 141.47 which means if the stock price is at 141.47 at expiration the 145 put will be worth its intrinsic value of 3.53 and the 135 put will be worthless and lastly the maximum loss potential of this position is 647 which will occur if the stock price is below both put spread strike prices at expiration if the stock price is below 135 dollars at expiration then the put spread will be worth its maximum value of 10 dollars which again is the distance between the two strike prices so if i shorted this spread initially and collected three hundred and fifty three dollars in premium and the value increased to one thousand which is its maximum value then i will lose six hundred and forty dollars so let's go ahead and take a look and see exactly what happened to this bull put spread in real life as the stock price was changing up and down through the trades duration so again the top portion of this graph features the changes in the stock price relative to the spreads strike prices as we can see early on in the trade the share price was falling which actually caused an increase in the put spread's value and since the bull put spread is a bullish strategy it will lose money when the stock price falls and it will make money when the stock price rises fortunately the shares regained traction and headed higher throughout the remainder of the trade and we can see that the further the stock price increased and as time passed the spread's value collapsed at around 17 days to expiration the spread's value was already very close to zero dollars which means the trade essentially already had the maximum profit potential and at that moment a wise trader would close the put spread to secure the near maximum profit closing the put spread would entail buying back the short 145 put and selling the long 135 put the p l on the trade would therefore be the difference between the hundred and fifty three dollars in premium collected at the time of entering the trade and whatever they paid to close the spread so if they paid twenty dollars to close the spread the profit on the trade would be three hundred and thirty three but as we can see the spread continued losing value and ended up with the maximum profit at expiration because with the stock price at 157 dollars and two cents at expiration the 145 put and the 135 put had no intrinsic value and therefore the spread's value was zero dollars so thus far we've covered both of the bullish vertical spread trading strategies which are the bull call spread which is buying a call spread and the bull put spread which is shorting a put spread so one of those is referred to as a debit spread meaning you pay to enter it which is buying the call spread and one of those is referred to as a credit spread which means you collect premium when you enter the trade and that is when you sell or short the put spread so you may be wondering when would you use the bull call spread and when would you use the bull put spread and we'll talk about that later in this section titled how to select the right strategy but for now we need to move on to the bearish vertical spread trades which are the bear call spread and the bear put spread so let's get started so the first of these bearish vertical spread trades that we will cover is called the bear call spread which is basically when you sell a call spread or short a call spread so the bear call spread is sometimes referred to as simply selling a call spread a call credit spread and that's it the next strategy we will cover is called the bear call spread which is referred to sometimes as selling a call spread or a call credit spread and a bear call spread is constructed by shorting a call option at one strike price and purchasing another call option at a higher strike price so it's basically the bull call spread from earlier except you do the opposite and instead of buying the call spread you actually short or sell the call spread as your opening trade and a bear call spread will make money as long as the stock price remains below the call spread strike prices so if you sell this call spread and the stock price is here it doesn't matter if the stock price goes up a little bit as long as the stock price is below the vertical spreads strike prices the trade will make money as time passes so let's look at an example in this example the stock price is at 141.46 at the time of entry and to construct the spread i will short the 142 call for 1.93 and buy the 145 call for 87 cents both options are in the 32 day expiration cycle so the entry price for this spread is 1.06 that is received since the call that i shorted the 142 call is more expensive than the call that i purchase and this results in a net premium collection at the time of entering the trade so let's look at the expiration payoff graph for this position as we can see the best case scenario is that the stock price is below 142 at expiration as that would lead to the 142 and 145 calls expiring worthless which means the call spreads value is zero dollars if i short the call spread for one hundred and six dollars and it expires worthless i'll make the full profit of one hundred and six dollars the break even price is one forty three oh six which means if the stock price is right at 143 dollars and six cents at expiration the 142 call will have intrinsic value of one dollar and six cents and the 145 call will expire worthless leaving the spread with a value of one dollar and six cents no profit no loss now if the stock price is at or above the upper strike of 145 the call spread will be worth its maximum price of three dollars because the strike width is three dollars and again we have to multiply these figures by 100 to get their actual values so if i short the spread for 106 dollars and it appreciates to a value of 300 i will lose 194 dollars but this is just the expiration payoff graph and we know that this does not reflect what will happen before expiration so let's go ahead and look at a performance visualization for this position to see exactly how the trade performed relative to changes in the stock price as time was passing the first thing to note is the correlation between the stock price and the spread price and since this is a bearish call spread trade i want the stock price to fall and be below 142 at expiration about halfway through this trade with 17 days to expiration we can see that the stock price was approaching the 145 dollar price level and we can see that the spreads value was at two dollars representing a unrealized loss of about ninety four dollars at that time but as a few more weeks passed we can see that the stock price declined steadily and with two days to expiration the stock price was well below the call spread strike prices and the spread price itself was almost zero dollars so with the best case scenario being that the spread price falls to zero dollars it would make sense at that moment to close that spread if the price gets close to zero dollars now to close a short call spread meaning a cost per that you sold as an opening trade you just need to buy back that same call spread to close it which would consist of buying back the short call and selling the long call so in this trade that would mean buying back the short 142 call and selling the long 145 call and this can be done in one transaction so if i paid 20 cents to buy back the spread my net profit would be 86 because i initially shorted the spread for one dollar and six cents in terms of this spreads value at expiration the stock price was at 142.26 which means the 142 call had intrinsic value of 26 cents and the 145 call expired worthless therefore the price of the 142 145 bear call spread at expiration was 26 cents or a real value of 26 dollars so if i shorted this spread for 106 dollars and it had value of 26 at expiration my profit would be eighty dollars all right so we've got one vertical spread strategy left and then we will get to the fun stuff at least in my opinion because the next sections are going to be critical in your understanding of vertical spread profitability and how you can make more and more money on your vertical spread positions the final of the four vertical spread strategies that we have to discuss is the bear put spread which is sometimes referred to as simply buying a put spread or a put debit spread since you pay to enter the put spread to enter a bare put spread position a trader will buy a put spread at one strike price and short another put option at a lower strike price and the goal is to see the stock price fall below both of the put spread strike prices and that would lead to the maximum profit at expiration and since the put that you purchase will be more expensive than the put that you short when you enter the trade this position will require that you pay to enter the position and for that reason it is sometimes called a put debit spread so let's take a look at an example and then move on to the more important and fun stuff at the time of entering this trade the stock price was at and 22 780.22 to construct this bare put spread we'll buy the 800 put for 44.88 and short the 750 put for 22.63 both options are in the 59 day expiration cycle the entry price of this spread is therefore 22.25 so let's go ahead and take a look at the expiration profit and loss diagram for this position and then visualize the trades actual performance the best case scenario is that the stock price falls below 750 and remains there at expiration because in that scenario the put spread will be worth the distance between the strike prices which is fifty dollars so if i buy a put spread for twenty two dollars and twenty five cents and it appreciates to fifty dollars i'll have a gain of twenty seven dollars and seventy five cents from the change in the spreads price but as we know we have to multiply that by 100 and we get a actual profit of 2775 dollars the break-even price at expiration is 777.75 and if the spread is right at seven hundred and seventy seven dollars and seventy five cents at expiration the eight hundred put that i own will have intrinsic value equal to twenty two dollars and twenty five cents and the seven fifty put that i'm short will be worthless and therefore the spreads price will be 22 dollars and 25 cents and i'll have no profit or loss at the time of expiration and of course the worst case scenario is that the stock price is above both put strikes at expiration in which case both options will have no intrinsic value and simply expire worthless in that scenario i'd end up having a worthless spread that i paid two thousand two hundred and twenty five dollars for in the beginning leaving me with unfortunately a 100 loss on the position but this is just the expiration payoff diagram so let's look at how this trade actually performed as the stock price changed understanding that this is a bearish trading strategy it would make sense that the trade lost money initially as the stock price was increasing in the first two weeks or so the stock price unfortunately went from 778 dollars to almost 850 dollars and we can see that the 800 750 bear put spread lost value falling from a price of 22.25 to a low of 10 the decrease to 10 represents an unrealized loss of one thousand two hundred and twenty five dollars and that's because i initially paid two thousand two hundred and twenty five dollars for the spread and a reduction in its price to ten dollars means the spread is worth one thousand dollars so we always have to multiply the spreads price by 100 to get its dollar value i know it's confusing but that's what we have to do as luck would have it the stock rally did not last long and the share price plummeted over the remainder of the trade and we can see that at 14 days to expiration the stock price was just above 750 meaning the 800 750 put spread was almost fully in the money the spreads price at that moment was around thirty four dollars or a value of thirty four hundred dollars the stock price fell even further reaching a low price of seven hundred and twenty dollars when the spread had around four days left until expiration and at that moment the spreads price was around forty seven dollars and fifty cents or just two dollars and fifty cents shy of its maximum potential value of fifty dollars and so the trader could have sold the spread at that moment for four thousand seven hundred and fifty dollars and secured a profit of two thousand five hundred and twenty five dollars so to close a put spread that you've purchased you simply sell that put spread in this example that would be done by selling the 800 put and buying back the short 750 put the trader held this position all the way to expiration the p l would have been seventeen hundred and sixty dollars but where does that profit come from with the stock price at seven hundred and sixty dollars and sixteen cents at expiration the 800 put had intrinsic value equal to 39.84 and the 750 put had no intrinsic value and therefore the price of the 800 750 put spread was 39.84 at expiration or a value of three thousand nine hundred and eighty four dollars and so if i bought this put spread initially for two thousand two hundred and twenty five dollars and it was worth three thousand nine hundred and eighty dollars at expiration my profit is 1 759 so we've covered the four vertical spread strategies and i know we've gone through a lot of examples and a lot of numbers in these past four examples but it's important that you understand the basic mechanics of these vertical spread trades and that's going to set you up for the next sections that we're going to talk about which in my opinion are much more exciting and i love talking about them and explaining them and these next sections are going to talk about vertical spread profitability versus the time left until expiration and also with changes in implied volatility and then i'm going to talk to you about how to select the right strategy for your particular situation and stock price outlook and then we'll close out the video by talking about what happens at expiration to a vertical spread and lastly do you have early assignment risk when you trade vertical spread positions so let's get started by talking about vertical spread profitability versus the time left until expiration this is perhaps one of the most important things to understand about vertical spread trading as the time left until expiration has a significant impact on how profitable your vertical spread will be depending on where the stock price is the reason this is so important is that you have to understand one law about vertical spreads and the law about vertical spreads is that to achieve the maximum profit potential on a vertical spread position both of the options in your vertical spread must have very little extrinsic value and more specifically to get to the absolute maximum profit potential the extrinsic value in your options will need to be zero which will happen at expiration or if the spread is so far in the money that the options have very little extrinsic value or no extrinsic value so basically the more time your spread has left until it expires the deeper in the money that spread will have to be to get close to the maximum profit potential but if your spread has very little time left until expiration or is expiring this day then the spread can just be fully in the money and it will be trading with very close to the maximum profit potential and subsequently expiring with the maximum profit potential because if the spread is fully in the money at expiration only intrinsic value will remain and the spreads value will have 100 of its maximum potential value which will be the width of the strike prices so in our earlier bull call spread example i had mentioned at one point in that example that the stock price was well above both call spread strike prices meaning the call spread was fully in the money but i had noted that the spread's price was not 15 dollars which is the width of the strikes instead the spread's price was around 12 or three dollars shy of its maximum potential value despite being fully in the money and the reason for that is because the spread was not close to expiration it still had multiple days left before expiration and because of that the options in that spread had lots of extrinsic value and because of the extrinsic value in those options the spread's price was not yet at its maximum potential value of 15 take a look again at that example and at around 18 days to expiration we can see that the stock price is around 150 250 but the 135 150 call spread was not worth its maximum value of 15 and as i mentioned the reason is because of extrinsic value if we just strip out the intrinsic value of these options we can calculate that at a stock price of 150 250 the long 135 call has 17.50 of intrinsic value while the short 150 call has 2 dollars and 50 cents of intrinsic value and therefore the net intrinsic value of the spread is 15 which is its maximum potential value and by net intrinsic value i mean the intrinsic value that i own and subtracting out the intrinsic value that i don't own or of the option that i'm short so basically if i need to sell that 135 call i can sell the 135 call for its intrinsic value of dollars and fifty cents and i have to pay two dollars and fifty cents to buy back the short 150 call assuming that i'm only paying and receiving intrinsic value and therefore if i collect 17.50 from selling the 135 call at its level of intrinsic value and i pay 2.50 to buy back the short 150 call at its intrinsic value of 2.50 then i will collect 15 which is the width of the strikes or the maximum potential value of that spread so why is it important to understand that the more time left until expiration the more extrinsic value these options will have which will prevent the spread from getting to its maximum potential value well the reason it's important is because if you buy a call spread or if you buy a put spread and you see a favorable stock price movement that leaves your spread fully in the money you have to understand that just because the spread is fully in the money it doesn't mean that you will have the maximum profit potential and that's because if the spread is fully in the money with lots of time left until expiration then there's going to be a lot of extrinsic value in those options and therefore the spread will not yet be trading at its maximum potential value or the width of the strikes so basically if you have a spread that becomes fully in the money you basically have to wait for time to pass for the extrinsic value to decay out of those options and therefore the spreads price will gradually approach its maximum value or the distance between the strike prices so i can prove this to you by just looking at various vertical spreads and changing the expiration date or changing the vertical spreads expiration cycle so that we can basically simulate the loss of extrinsic value or the increase in extrinsic value and see how that affects the spreads price so let's hop over to the tastyworks trading platform so i can show you some real examples of this and we can understand that a fully in the money vertical spread will be trading much closer to its maximum value than that same vertical spread with more time until expiration so let's hop over to the trading platform right now and take a look so first thing i want to point out is it's an absolute bloodbath today in the market we have s p down 125 or three and a half percent nasdaq is down 630 points or over five percent that's disgusting all right anyways let's go to let's go to apple so what i'm going to do is i'm going to queue up a vertical spread that is fully in the money so for this i'm going to look at it call spread so apple's current price is 122.75 so i'm going to look at the 100 110 call spread and let's look at a long dated expiration cycle such as november 2020 so if i purchase or queue up an order to purchase the 100 call and then i'd queue up an order to short the 110 call we can see that this call spread is fully in the money because this is the 100 110 bull call spread and apple is currently at 123 dollars so this call spread is fully in the money but we can see that the spreads price itself is 6.95 and the most that this spread could be worth at expiration is ten dollars so let's go ahead and look at the 100 110 call option in a much shorter term expiration cycle and see if the spread price is higher or lower than seven dollars so right now it's jumping around a bit because it's a volatile trading day but we can still gauge the increase in this spreads price as time passes by simply looking at the same spread in a shorter term expiration cycle so let's go to september if iq up in order to purchase the 100 call and short the 110 call we can see that the 100 110 call spread with 15 days to expiration as opposed to 78 days to expiration this shorter term call spread that is fully in the money is trading for about eight dollars and 85 cents so basically two dollars more than the same exact call spread with 60 days more until expiration and the reason for this is that 15 day options have much less extrinsic value than 78 day options and for that reason if you look at an in the money vertical spread that has less time until expiration its price will be much closer to the maximum potential value as compared to that same exact vertical spread with much more time until expiration so the next thing we will talk about is vertical spread profitability versus changes in implied volatility which relates directly to the extrinsic value statements that i made earlier because implied volatility literally measures extrinsic value in options so if implied volatility increases that's an indication that the options have become more expensive extrinsically relative to the amount of time they have until expiration and on the other hand if you see a decrease in implied volatility that means that the options now have less extrinsic value than they had before relative to the time left until expiration so basically if we hold the stock price constant and we have no passage of time a decrease in option extrinsic value results in a lower level of implied volatility and on the other side of things an increase in extrinsic value holding the stock price and time constant will lead to an increase in implied volatility so here are two things that you need to keep in mind and kind of internalize the first thing is that if you buy a call spread or you buy a put spread you want the stock price to move so that that spread becomes in the money and if you buy a call spreader put spread and it becomes fully in the money you want implied volatility to decrease meaning that you want the options to have less extrinsic value relative to the time left until expiration because with less extrinsic value in those options through a decrease in implied volatility means that the spreads price will actually expand towards the width of the strikes or its maximum value potential so if you have a 20 wide call spread and the stock price increases above both call strike prices you want implied volatility to decrease because then that means that these options have less extrinsic value and because of that the spreads price that you have which is 20 wide will appreciate towards 20 or its maximum potential value the second thing that you should internalize is that if you short a call spread or you short a put spread and the spread is out of the money which is a good thing for you then again you want implied volatility to decrease because that means that there is less extrinsic value in your vertical spreads options and less extrinsic value means that you will see a contraction in your out of the money vertical spreads price because with no intrinsic value if your spread is out of the money and it loses extrinsic value which is all that it consists of then that spreads price will fall closer towards zero which is when you would realize the maximum profit potential now i don't like telling you things to just memorize so let me explain these things that i've just said intuitively a broad decrease in the extrinsic value that exists in a stocks options meaning a decrease in implied volatility means that the option market is expecting less volatility from that stock price in the future which means that there is a higher probability that the stock price will be somewhere around its current price in the future as compared to before so if you own a call spread meaning you purchase a call spread and the stock price is fully above your call spread strike prices a decrease in implied volatility meaning less extrinsic value in those options means that there is a higher expected probability that the stock price will be somewhere around its current price in the future which means that there is a higher implied probability that your in the money vertical spread will be in the money at expiration and if the probability or the implied probability of your vertical spread being in the money at expiration increases the spreads price will increase so basically if your spread is fully in the money and you own that vertical spread meaning you buy a call spread and the stock price shoots higher you want implied volatility to decrease because a decrease in implied volatility means that there is a higher implied probability that the stock price will still be above your call spread strike price at expiration and because that means your spread has a higher probability of being fully in the money at expiration the spreads price will increase towards its maximum potential value and the same is true if you are short a put spread or short a call spread when you short a put spread you want the stock price to be above your put spread strike prices because then that means the puts have only extrinsic value which if the extrinsic value decreases that means the spreads price will fall towards zero dollars so if you have a put spread that you've shorted and the stock price is above the put spread strike prices a decrease in implied volatility means that the extrinsic value has decreased in those options which will lead to a contraction in the put spreads price towards zero but the reason this makes sense is because if you have a put spread that you've shorted and the stock price is above your put spread strike prices a decrease in implied volatility means that there is a lower expected range for the stock price and therefore the probability that your put spread expires out of the money increases and if there is a higher probability of your put spread expiring worthless the price of that put spread will fall so if you are short a put spread and it is out of the money and implied volatility contracts that means that there is a higher probability that your put spread will expire out of the money or worthless because there is a lower expected stock price range than there was before when implied volatility was higher you may have heard that when implied volatility is low it is good for debit spreads meaning when implied volatility is low it's better to buy call spreads and buy put spreads because the increase in implied volatility will benefit the position somehow because you are net long options i mean you've you've purchased options essentially and that's simply not true because if you buy a call spread or you buy a put spread you want the stock price to move through the strike prices and when that happens and when your spread becomes in the money you want implied volatility to decrease because that means there's less extrinsic value in the options and that means the spreads price will increase towards its maximum potential value and intuitively that's because if your spread that you own is fully in the money and a decrease in implied volatility occurs that means that there is a higher probability or higher implied probability that your spread will expire in the money and if your spread expires in the money it will expire with its maximum potential value or the width of the strikes so a favorable movement with a vertical spread combined with a decrease in implied volatility is always a good thing the only time an increase in implied volatility is good is if the stock price is not in a favorable situation meaning if you buy a call spread and the stock price is below the call spread meaning the call spread is out of the money an increase in implied volatility is good because it means that there's a larger potential range for that stock price or expected range for the stock price and that means that there is a higher probability that your call spread will expire in the money and because of that increase in the probability of the call spread expiring in the money the call spreads price will increase but if the call spread is in the money you want implied volatility to decrease because you want the implied probability of the call spread expiring in the money to increase so i know this is a lot and it's it's a little more complicated than the simple examples that we talked about earlier but it is a critical thing to understand because it doesn't matter if you are shorting a vertical spread or if you are purchasing a vertical spread if the stock price is moving in favor of your vertical spread meaning that your your call spread that you purchase is in the money or the put spread that you've shorted is out of the money you want implied volatility to decrease 100 of the time the only time an increase in implied volatility is good is if you own a call or put spread that is out of the money or if you are short a call spread or put spread that is in the money all right so let's move on to the last sections of the video which is first how to select the right strategy for your given outlook and then we'll talk about what happens at expiration and early assignment risk so given that there are four different vertical spread strategies you can choose from which one should you actually use depending on your particular scenario or stock price outlook it's really a matter of preference but here are some guidelines to help you out first if you are expecting a strong directional movement from the stock then in my opinion it would be better to buy a call spread or buy a put spread since that would be a trade that you could structure in a way to have very favorable risk reward if you are right about your strong outlook for that stocks potential movement in the future and guideline number two is if you are not expecting a super strong movement in either direction but you want directional exposure and you want to place a higher probability trade to profit if the stock price moves in favor of whatever direction you want but also could move against you slightly then in that scenario i think it would be better to go with the credit spread strategies which means you short a call spread in which case the strategy will make money so long as the stock price remains below the call spread or you short a put spread which will give you bullish exposure but the strategy will make money so long as the stock price remains above the put spread strike prices so let's hop over to the tastyworks trading platform and i will show you some example trade setups with these four vertical spread strategies so that you can understand kind of the differences that you'll get with different strike price selection methods and the risk reward that you'll get with those trade structures so let's check it out so right now i have netflix pulled up on the trading platform and we can see that netflix is currently trading for 525 dollars per share so let's say i think that netflix is going to experience a very strong directional movement to the downside and i want to profit from that assumption so i think netflix will continue losing substantial value in the share price of my bearish vertical spread strategies i could either buy a put spread and the other option is to short a call spread so it's between the bear call spread and the bare put spread so let's look at going to the october expiration cycle with 43 days to go and with netflix at 525 let's look at buying the 525 put and then look at shorting the 500 put so this would give me a put spread with a cost of 11.45 and that means my maximum loss potential is right around that number let me just lock this price so if the price of the put spread is 11.65 my maximum loss potential is 1 165 but my maximum profit potential is 1 35 so basically the way i constructed this put spread is to purchase the at the money option and short a further out of the money option so this is just one way that you could set this trade up but the reason i like this and the reason i would suggest buying a call spreader put spread with a strategy or structure similar to this one is because it'll give you favorable risk reward and that will be beneficial to you if you are correct about your strong directional outlook for the stock so in this case my maximum profit potential is slightly higher than the amount i can lose and because of that if i'm wrong i will lose less than i will make if i am actually right so if i'm right about my stock price prediction that netflix will fall then my profit potential is actually 1 35 and if i'm wrong then i will actually lose less than that and my maximum loss potential is 1 165 so let's compare this risk profile with the bear call spread so with netflix at 526 let's look at i could even look at selling the 525 call and then purchasing the 550 call so what we'll notice here is that if i short the 525 550 call spread which is 25 dollars wide just like the put spread was that i just looked at in this case i'll make money as long as netflix is below 525 at expiration in 43 days so since i can sell this spread right now for and ninety five cents my maximum profit is one thousand ninety well let me just lock this if i sell this for eleven dollars my maximum profit is eleven hundred dollars but if netflix is above 550 at expiration then this spread will be worth 25 dollars and if i short it for 11 and it goes to 25 i'll have a 14 loss which means my maximum loss on this is actually 1 thousand four hundred dollars so when we compare these two strategies of either shorting the 525 550 call spread versus buying the 525 500 put spread we can see that this has less favorable risk reward so i can lose more than i can make if i'm right but the benefit of using this call spread strategy over the put spread strategy is that it has a higher probability of making money because as long as netflix is below 536 at expiration which is this position's break even price this position will make money whereas if i buy the 525 500 put spread for 10 then i actually need netflix to be below 515 at expiration so the reason that i said if you have a strong directional outlook for a stock then buying the spread is probably better then the reason i said that is because you'll have more favorable risk reward if you set it up in this manner but i have to drop something on you right now call spreads and put spreads buying them and selling them are effectively the exact same strategy just with calls and puts so buying a call spread is the same exact thing as shorting a put spread with the same strike prices so let me demonstrate that to you right now so as opposed to shorting the 525 550 call spread if i purchased the 550 525 put spread which is essentially fully in the money we will see that the risk profile is very similar so for the 525 550 short call spread the max profit is around 10.50 the max loss is around 14.50 if i buy the 550 525 put spread the max profit is 10.85 the max loss is 14.15. now keep in mind that these prices are changing as the stock price is changing and it's a pretty volatile day so they're not going to be exactly the same but if we roughly compare the risk to reward of shorting a call spread or buying a put spread using the same strike prices they will essentially have the exact same risk profile so if we do that once more go back to well let's look at a different example if i short the 500 475 put spread this has max profit of 925 maximum loss potential of 15.75 but to get the same exact position i could look at buying the 475 500 call spread so let's see what the risk reward profile for that is so buy the 475 short the 500 max profit 965 max loss 1535 so they are very similar in nature and this gets into the realm of option synthetics which is how you can construct the same option positions in different ways but the reason that i'm bringing this up is because i think it is awkward to purchase an in the money vertical spread much like i think it is awkward too short and in the money vertical spread so if you want to place a high probability trade then i think it is better to and out of the money vertical spread or if you want a very favorable risk to reward trade based on a very strong directional outlook then i think it is better to buy and at the money or out of the money vertical spread as compared to buying a deep in the money vertical spread because if you buy an in the money vertical spread the profit potential will be less than the risk and if you buy an out of the money vertical spread the profit potential will be more than the risk so when you have a very strong directional outlook for a stock i think it is more beneficial to give yourself better risk reward as compared to putting on a higher probability trade where if you're right about that strong directional outlook you'll make a little bit of money but if you're wrong you'll lose more than you could have made so it's really a matter of preference and i would encourage you to go on the trading platform and play around with different trade structures and see what the risk and the reward profile is for those vertical spreads but in my opinion if you have a very strong directional outlook for a stock then i think it is better to buy a call spreader put spread namely one that is at the money meaning you buy and at the money strike and short and out of the money option or you even purchase an out of the money vertical spread because those will give you the most favorable risk to reward profiles alright so let's close out this video by talking about what happens at expiration to a vertical spread and is there early assignment risk when you are trading vertical spreads so understanding what happens to a vertical spread is fairly simple because at expiration any option that is in the money that is held through expiration will automatically be exercised so for vertical spreads what this means is that if your vertical spread is out of the money meaning the options have no intrinsic value then add expiration those options will expire worthless and they will not convert into any stock positions so those worthless options will simply disappear from your trading account and that'll be it now if your vertical spread is fully in the money which means both of the options in the vertical spread have intrinsic value and you hold that position through expiration then both of the options will actually automatically be exercised and convert into the corresponding stock positions associated with whether that's a short or long call or a short or long put so for example if i have a 125 130 call spread that i've purchased and the stock price is at 135 at expiration and i hold the spread through expiration the long 125 call that i own will automatically get exercised and i will buy 100 shares of stock at 125 dollars per share but the 130 call that i am short will also automatically be exercised and since i'm short that option that means i will be assigned on the short 130 call and that means i will sell 100 shares of stock at 135 or 130 dollars per share so basically what will happen if the 125 130 call expires in the money i'll buy 100 shares at 125 and i will simultaneously sell those shares at 1 30 and basically i will make 500 on that difference because i will buy 100 shares at 125 and i will sell those 100 shares at 130 pocketing the 500 gain on that transaction but if i paid two hundred and fifty dollars for the spread when i entered the trade my net profit would be two hundred and fifty dollars in that particular example so if the vertical spread is fully in the money and you allow it to expire in the money then the exercise and assignments will offset and you will not end up with any stock position after expiration regardless of that though you will pay exercise and assignment fees based on whatever your brokerage firm charges and i actually would not recommend holding a vertical spread through expiration just because you have the option to close it before expiration in which case you don't have to worry about what's going to happen when those options expire in the money so in general i think it is a good idea to always close option positions before expiration unless they are extremely deep out of the money and they're just going to expire worthless anyways but lastly what happens if a vertical spread is only partially in the money at expiration let's say i buy the 100 put and i short the 90 put and the stock price is at 93 at expiration well the 100 put is in the money and the 90 put is out of the money so this means if i hold the position through expiration the 100 put that i own will automatically be exercised and i will therefore short 100 shares of stock at the put strike price of 100 so i will end up with a stock position which would be shorting 100 shares of stock at the put strike price of 100 but the 90 put that i shorted initially will expire out of the money because it doesn't have any intrinsic value if the stock price is at 93 and because of that the 90 put will expire worthless but the 100 put that i owned will be exercised automatically and i will effectively short 100 shares of stock at that put strike price of 100 so if your vertical spread is only partially in the money meaning the stock price is in between the strike prices when it expires if you hold that spread through expiration you will end up with a stock position and again as i mentioned earlier i think it is a good idea to close vertical spreads before expiration especially if they are partially in the money because in that scenario you will end up with a stock position and in most cases you probably won't want to be taking the stock position because if you're trading options especially if you're trading in a smaller account that stock position is going to represent a value that is significantly larger than whatever option position you have and for that reason if your spread is partially in the money at expiration i would really recommend closing that spread before it expires so that you don't end up with a stock position and especially if you don't want the stock position and lastly is there assignment risk when trading vertical spreads and the answer is yes since there is a short option component of all of the four vertical spread strategies when you're trading a vertical spread if the vertical spread is in the money meaning that the short option is in the money then theoretically you do have risk of being assigned on that short option because the only time you'll be assigned on a short option is if it is in the money but at the same time there really is not a high risk of early assignment because if you're short and in the money option and it has lots of extrinsic value in its price it is very unlikely to be exercised by the person that owns it because whoever exercises the option with extrinsic value will effectively burn the extrinsic value in that option and give it up unnecessarily so for that reason a rational trader would never exercise an option that has lots of extrinsic value and if they did exercise an option that had lots of extrinsic value they would essentially be forfeiting all of that extrinsic value and if you're short that option that means you will actually be benefiting by the amount of that extrinsic value in the case of early assignment there is a early assignment risk when you're trading vertical spreads primarily if the short option is deep in the money with very little extrinsic value but in the case of buying a call spread or buying a put spread if the spread is so deep in the money that the short option has very little extrinsic value that also means that the long option that you own also has very little extrinsic value and for that reason that means the spread is probably trading for very close to its maximum potential value and you should be closing it anyways if you own a call spread or you own a put spread there should never be a scenario where you're worried about early assignment because in the case where you could be assigned early on that short option because it is in the money with very little extrinsic value that means your put spreader call spread is already trading near the maximum profit potential and therefore you should close that position now on the other hand if you are short a call spread or you are short a put spread and it is fully in the money then your short option is actually going to have less extrinsic value than the long option and in this scenario you are much more likely to be assigned before expiration since your short spread is actually fully in the money and that means you have a losing position it's a little harder to tell you to close that spread because it is illogical to close a vertical spread that is close to the maximum loss potential because you have very little left to lose but you have everything left to gain so it's a little trickier when you're short a call spread or put spread and it is deep in the money with early assignment risk because in that scenario the spread is probably trading at a point that leaves you with near the maximum loss potential and in general if you have already lost almost all you can lose on a trade it doesn't make sense to close it but in this case it's tricky because if you continue holding that position there's a chance that you'll get assigned early on that short in the money option but keep in mind that that does not hand you a huge loss because you still have the long option that is also in the money and you could just close the stock position and close the long option to unwind that position or you could exercise the in the money option that you own which would effectively close out that stock position that you were assigned into but again i would not recommend exercising an option if it has lots of extrinsic value so there's a lot to know there and a lot to think about but in general you should not worry about early assignment risk with vertical spreads because like i said if you're buying if you're buying the spreads so you're buying a call spread or buying a put spread by the time you get to any situation where you have early assignment risk your trade is going to have the max profit and it should be closed but if you are shorting call spreads or shorting put spreads it's a little trickier because by the time you get to an early assignment risk scenario then your position is going to have close to the maximum loss potential and that means that you've already lost everything you can lose on the trade and in those situations it's illogical to close the trade but if you want to avoid the early assignment risk the only option you have is to close that vertical spread alright so that's going to do it for today's ultimate guide to the vertical spread option strategies i really hope you enjoyed this video and learned a ton from it i covered not only the basics but i covered some more advanced material that i would encourage you to study namely the vertical spread profitability versus time to expiration the vertical spread profitability versus changes in implied volatility and both of those things relate to extrinsic value so we not only covered the basics today but we covered some more heavy hitting material but if you can master your understanding of everything that i've described in this video as i said earlier you will make a gigantic leap forward in your options trading expertise if you enjoyed this video i would really appreciate if you gave it a like for me down below and if you left me a comment letting me know what you liked about this video or what you've learned and if you have anything else to add that other people could benefit from please leave that down in the comment section below my name is chris from project option and i will see you all in the next video [Music] you

Channel: projectfinance

Views: 515,862

Rating: 4.9101744 out of 5

Keywords: vertical spread option trading, vertical spread options trading, vertical spread options strategies, bull call spread, bear call spread, bull put spread, bear put spread, credit spread options, debit spread options, intrinsic value, options trading, projectoption, chris butler, stock market, options trading strategies, bullish options strategies, bearish options strategies, implied volatility, time decay, extrinsic value options, options trading for beginners, call spread

Id: mwttDWfDQ9c

Length: 73min 4sec (4384 seconds)

Published: Fri Sep 18 2020