Vertical Spread Trading Tips (ESSENTIAL CONCEPTS)

in this video I'm going to share with you some tips and tricks that are going to help you when trading the four vertical spread option strategies more specifically I'm going to cover topics including the relationship between extrinsic value and the profitability of a vertical spread I'm also going to talk about why debit spreads are not low implied volatility trades we'll discuss choosing an expiration cycle and strike prices for your vertical spreads and I'll also talk about some strategies for taking profits and taking losses when trading vertical spread strategies be sure to StayTuned the four vertical spread strategies are some of the simplest yet some of the most powerful strategies out there and they serve as the building blocks for more popular strategies such as the iron Condor and butterfly trading strategies the four vertical spread strategies are the bull call spread bull put spread bear call spread and bear put spread I've created individual videos on each of these strategies and I've linked those videos down below so if you want to watch a video on each of those strategies be sure to check those links after watching this video in this video I'm gonna teach you concepts that you have to know before trading vertical spreads as well as some tips and tricks related to each of these must know concepts the first item on our list is the relationship between extrinsic value and the profitability of a vertical spread trade the major concept that you need to understand here is that to achieve the maximum profit potential when trading vertical spreads the extrinsic value must come out of the options that comprise the spread extrinsic value decreases as time passes as the stock price moves in favor of your vertical spread or as implied volatility decreases which is just another way of saying that there is a broad decrease in the extrinsic value that exists in a stocks options a broad decrease in extrinsic value of a stocks options is synonymous with a decrease in implied volatility since implied volatility measures extrinsic value of a stocks options relative to the amount of time that those options have until they expire let's go over a few real-world examples so I can demonstrate to you exactly what I mean by needing the extrinsic value to come out of a spreads options for that spread to achieve its maximum profit potential in this example I looked at a call spread on JP Morgan that was completely in the money at the time of recording the stock price and the options that comprised the call spread with JP Morgan add a hundred and eight dollars and 66 cents I looked at the 95-105 call spread with 52 days until expiration that call spread was trading for eight dollars and 53 cents despite being fully in the money at the time of recording the spreads price the maximum value of a vertical spread at expiration is the width of the strike prices and in the case of this 95-105 call option the strike prices are ten dollars apart which means this call spread has a maximum value potential of $10 per spread at the time of expiration at the time the 95 call option was trading for $13.98 32 cents of which was extrinsic the 105 call was trading for five dollars and forty-five cents in which one dollar and seventy nine cents of that price was extrinsic value if we take the extrinsic value out of both options in this spread the spreads value would be ten dollars which is its maximum potential value since the strike width is ten dollars in the case of the 95-105 call spread that means that if I bought this call spread for its current price of eight dollars and 53 cents and the extrinsic value came out of the options thereby increasing the spreads value to ten dollars since it's fully in the money I would experience a profit of one dollar and forty seven cents per call spread that I purchased which means I would have a profit of one hundred and forty seven dollars for every call spread purchased when we account for the option contract multiplier of 100 so if you're ever wondering why a call spread or put spread that you own is not worth its maximum value potential or the width of its strikes yet the cost bread or put spread is fully in the money at that time the reason the spreads value is not its maximum potential value is because there's extrinsic value in those options and for a vertical spread to achieve the maximum profit potential all of the extrinsic value must come out of that spread now I'm going somewhere with this so stick with me let's take a look at a credit spread on JP Morgan and go through the same steps so I can demonstrate to you why and out of the money credit spread has value but be worthless or achieve the maximum profit potential if the extrinsic value came out of the options let's look at an out of the money credit spread example on the same exact stock with JPMorgan at 108 dollars and 66 cents I looked at the 110 120 call spread with 52 days until expiration and the 110 120 call spread was currently trading for two dollars and 32 cents with JP Morgan at 108 dollars and 66 cents both the 110 and 120 call options are completely extrinsic because both of those options are out of the money since JP Morgan's stock price is below both of the strike prices of 110 and 120 that means that this 110 120 call spread is 100% extrinsic value that means that if I sold the 110 120 call spread for two dollars and 32 cents all of which being extrinsic and those options lost all of their extrinsic value and went to zero dollars I would have a $2 and 32 cent profit on this credit spread because if I sell a call spread for two dollars and 32 cents and its price goes to $0 I'll have a $2 and 32 cent profit per spread so again in this example the maximum profit potential occurs from all of the extrinsic value coming out of the vertical spreads options so where am I going with this whole extrinsic value thing because all of the extrinsic value must come out of a vertical spread for the spread to achieve its maximum profit potential we can use that information when choosing an expiration cycle to trade and also understanding what we want implied volatility to do after we've entered the vertical spread which brings me to the considerations we need to make when choosing an expiration cycle for our vertical spread positions when choosing an expiration cycle for a vertical spread trade it may seem beneficial to choose a longer dated expiration cycle such as one with 90 or more days until expiration because you can give yourself more time for your directional outlook to play out since vertical spreads are directional trades however keep in mind that longer-dated options experience slower rates of extrinsic value decay which means that if you trade a longer dated vertical spread you will have to wait longer for the extrinsic value to come out of those options means you're gonna have to wait longer to achieve higher levels of profitability on that spread if you trade a shorter term expiration cycle such as one with fewer than 30 days until expiration you'll have less time for your directional outlook to play out but you will experience quicker profits on your vertical spread if your directional assumption is correct and the stock price moves in favor of your position let's look at an example so I can prove this to you using an option pricing calculator I compared two scenarios one with a 30-day call spread and one with a 90-day cost spread using the same exact strike prices so I could simulate the profitability of each call spread based on the same exact stock price movement on a $100.00 stock trading with 20% implied volatility the 100-105 call spread with 30 days until expiration was estimated to be valued at one dollar and seventy four cents if the stock price increased to 105 dollars on that same exact day the 30-day 100-105 call spread is estimated to be worth three dollars and 34 cents which is a one dollar and sixty cent increase from the initial purchase price of one dollar and seventy four cents on the same 100 dollar stock trading with 20% implied volatility if we start with the stock price at $100 the 90 day 100 105 call spread is estimated to be valued at two dollars and nine cents if the stock price increased to 105 dollars on that same exact trading day the 100 105 call spread with 90 days until expiration was estimated to be valued at three dollars and five cents which represents a 96 cent increase from the initial purchase price of $2.99 simulation validates because the 30-day call spread experienced a $1 and 60 cent increase but the 90 day call spread using the exact same strike prices and experiencing the same exact stock price movement only experienced a 96 cent increase in the spreads valuation for the 90-day call spread to experience the same $1 and 60 cent profit that the 30-day call spread experienced the stock price would have had to increase from 100 dollars to about 110 dollars on the same exact trading day for the spreads profit to reach about one dollar and sixty cents the stock price had to increase twice as much on the same trading day for the 90 day call spread to achieve similar profit levels as the 30 day call spread all else being equal in other words when trading longer-term vertical spreads you're going to need a much larger stock price movement in the favor of your spread to reach similar levels of profitability compared to the same exact spread with fewer days until expiration said another way if you give yourself more time to be right directionally you will be rewarded less if you're correct about that directional assumption because by giving yourself more time obviously that's easier than giving yourself a less time with a directional assumption and by making it easier for yourself your reward will not be as high as giving yourself less time therefore making it more difficult for you to make a directional play generally speaking trading vertical spreads with 30 to 60 days until expiration is a happy medium between not giving yourself enough time to be right directionally and giving yourself too much time to be right directionally thereby decreasing your reward potential if you are correct about your directional assumption the second essential concept that you need to understand when trading vertical spreads is that debit spreads are not low implied volatility trades meaning that debit spreads are not optimal when purchased in low implied volatility environments here's why you may have heard that credit spreads are great when implied volatility is high and debit spreads are great when implied volatility is low the thinking behind that is when you're trading a credit spread you are selling options meaning you're selling a call spread or selling a put spread and selling options is best done when implied volatility is high because if you sell options and implied volatility decreases or the extrinsic value of the stocks options decreases that's going to be beneficial for you as an option seller conversely since trading debit spreads means your buying a call spread or buying a put spread and buying options is best done in a low implied volatility environment because an increase in implied volatility will benefit your option buying position in reality debit spreads benefit from decreases in implied volatility just like credit spreads as long as the stock price is moving in favor of your spread let me go ahead and prove that to you by using the same simulations from before on a $100 stock with options trading at 20% implied volatility the 100 105 call spread with 30 days until expiration is estimated to be valued at $1 and 74 cents assuming the stock price is right at $100 if the stock price increased to 105 dollars on that same exact trading day the 100 105 call spread with 30 days to expiration is estimated to be worth three dollars and 34 cents which represents a $1.00 in 60 cent increase from the initial purchase price of $1.00 and 74 cents in this scenario we're assuming that implied volatility stays right at 20% through that stock price movement however if the stock price increased to 105 dollars and implied volatility went from 20 percent to 15 percent indicating a broad decrease in extrinsic value of the stocks options the 100 105 call spread is estimated to be worth three dollars and 59 cents which represents a $1 and 85 cent increase over the initial purchase price of $1.00 and 74 cents finally if the stock price increased from $100 to 105 dollars and implied volatility actually increased from 20 percent to 25 percent indicating an increase in the extrinsic value that exists in the stocks options the 100 105 call spread is estimated to be worth three dollars and 16 cents which represents a $1 and 42 cent increase from the initial purchase price of $1.00 and 74 cents of all these scenarios the one that generates the highest profit for the 100 105 call spread is the $5 stock price increase combined with a 5% implied volatility decrease all that we need to know here is the best case scenario is a favorable movement for the call spread combined with a decrease in implied volatility because a decrease in implied volatility all that is is a broad decrease in the extrinsic value that exists in the stocks options the only time an increase in implied volatility is good when trading debit spreads is that the stock price is moving against your spread for example if you buy a call spread and the stock price is decreasing an increase in implied volatility will help your position lose less money compared to no change in implied volatility in the case of buying a put spread an increase in implied volatility is only helpful to your long put spread if the stock price is increasing which is the exact opposite direction that you want the stock price to go in these next sections I'm going to talk about selecting strike prices when trading debit spreads and credit spreads first we're gonna start with debit spreads there are many different approaches that you can use when selecting strike prices when trading debit spreads each approach has implications for the probability of making money on the spread and therefore the risk and reward potential of that particular trait in this next section I'm going to use the tasty works trading platform so that I can walk through these debit spreads strike price selection methods in real time using real option prices and real spreads be sure to check the link in the description to see how you can get one of our paid courses completely free when you open and fund your first tasty works brokerage account using the project option referral code let's get over to the platform right now I'm on the tasty works trading platform and currently I have up the trade page of I WMS options and IWM is the Russell 2000 ETF so I'm gonna go ahead and open up the August 2019 - show me the August 2019 I double um and these options have 50 days until expiration the first debit spread setup I'm going to show you is an in the money spread so that means you're buying an in the money option and you're also selling it in the money option which means the spread is already fully in the money when you enter the trade and that means all that has to happen is the stock price has to remain at its current level or move even more in favor of your spread and you will make money on this trade as time passes because the extrinsic you will come out of that spread an example of a in the money debit spread on IWM would be to buy the 1:45 call and sell the 150 call to create the 145 150 call a debit spread this spread is fully in the money since IWM is above 150 dollars as IWM is at 150 270 buying an in the money spread is a high probability trade because IWM just has to stay at its current level or even decrease a little bit and this spread can still achieve the maximum profit potential at expiration in 50 days because of the fact that this is a high probability spread the profit potential is going to be far less than the loss potential and in this case if the spread is trading for three dollars and seventy eight cents the maximum loss potential is three hundred and seventy eight dollars per spread and the maximum profit potential is one hundred and twenty two dollars per spread so obviously the profit potential is far less significant than the loss potential so in other words if you buy in the money spreads you will have more risk than reward potential because of the fact that that is a high probability trading strategy and if we look to the bottom left here this probability of profit of sixty five percent means that if I hold the trade through expiration there's an estimated 65 percent probability that I will have at least a one penny profit on this position the second debit spread setup I'm going to show you is buying an in the money option and selling it out of the money option and if you use that setup and the stock price is right in between the two strike prices your debit spread will have about a 50% probability of profit and the risk to reward ratio will be fairly even meaning that your risk is about the same as the reward so an example of that with IWM at 150 to 77 would be to buy the 150 call option and sell the 155 call option in which case we can see the probability of profit is estimated to be about 50% and the break-even price in this particular example would be 150 plus 298 which is 150 to 98 and that means the breakeven price is about 20 cents higher than iw M's current price of 152 76 since this is a lower probability trade the maximum profit potential here is 202 dollars and the maximum loss potential is 298 dollars which is a more favorable risk to reward profile than the 145 150 call spread which we saw had a profit potential of one hundred and twenty two dollars and a loss potential of three hundred and seventy eight dollars so when you buy an in the money option and sell an out of the money option and the stock price is right in between your two strike prices the spreads probability of profit will be right around fifty percent and your profit and loss potential will be fairly even but in this case the profit potential is still slightly less than the loss potential the third and final setup you can use when trading debit spreads is to buy and at the money or out of the money option and then sell an even further out of the money option and this type of debit spread will have the most profit potential the lowest risk but also the lowest probability of making money compared to the other two spreads that we just looked at so an example of buying and at the money option and selling an out of the money option would be to purchase the 153 call option on IWM which I know is technically out of the money since it's 18 cents above the IWM stock price of 150 to 82 but this is the closest at the money strike price to IWM s current price so if I bought the 153 call option and wanted to create a $5 wide call spread I could sell the 158 call option and now I have the 153 158 called debit spread queued up as we can see here the price is at $2 and 36 cents and the maximum loss potential in that case is two hundred and thirty six dollars per spread and the maximum profit potential is two hundred and sixty four dollars per spread so compared to buying an in the money call spread or buying an at the money call spread this type of debit spread setup will have the highest profit potential relative to the risk but it will also have the lowest probability of profit because for this spread to reach maximum profitability IWM it needs to increase to one hundred and fifty eight dollars in 50 days for this spread to reach its maximum potential value five dollars now you'll see that if I move the strike prices even further out of the money the price of the spread decreases and that means that the profit potential increases and lost potential decreases but as you get further and further out of the money with your spread the probability of profit also decreases because you need a larger and larger stock price movement in your favor for that spread to reach its maximum profit potential at expiration just keep in mind that the risk and reward potential is directly correlated to that spreads probability of success and if you are a trader who wanted to have a high probability to have spread that means you're gonna be buying in in the money spread and if you want to trade a debit spread with about a 50% probability of making money then that means you're going to be buying it in the money option and selling and out of the money option ideally with a stock price right in between your two options as would be the case with this one 51:55 call spread next I'll walk through different setups when selecting strike prices for credit spreads again I'm going to use the tasty works desktop trading platform so you can see these concepts in real time and with real credit spreads using IWM as we did in the previous examples let's go over the most common ways to set up credit spreads which is essentially either selling an at the money option and buying an out of the money option which would be selling and at the money credit spread so to speak or selling an out of the money option and then purchasing and even further out of the money option which would be selling an out of the money vertical spread in the first example we would be selling a near at the money option and with IWM at 150 to 84 that could be selling the 150 to put option and to create a $5 wide put credit spread i could purchase the 147 put and this would create the 150 to 147 put credit spread this current spread is trading for one dollar and 48 cents and that means the maximum profit potential is 148 dollars since there is 148 dollars of extrinsic value in the spread and if all of the actions occur alyou comes out of the spread this will reach the maximum profit potential of 104 eight dollars the maximum lost potential in this case is 352 dollars and since the loss potential is substantially more than the profit potential in this case we know that that means that this is a high probability trade and the P o P and the bottom left corner here says 59% for the probability of profit and that means if I sold this spread for $1 and 48 cents and held it through expiration in 50 days there's an estimated 59 percent probability that I would have at least a one penny profit on this trade so this would be the most aggressive way you can trade a credit spread the second way to trade a credit spread would be to sell and even further out of the money spread and in this case let's say I wanted to sell the 148 put option and by the 143 put option this is still a $5 wide put credit spread but since this is further out of the money and therefore has a higher probability of making money the profit potential is going to be less than the lower probability spread and the maximum loss potential is going to be even greater up next I'm going to discuss the logic and trade management techniques that you can use when trading vertical spread positions the first thing to keep in mind when trading vertical spreads is that it becomes more and more logical to take profits on that spread and close it the more profitable the spread gets because as a spread gets more and more profitable you have more to lose and less to gain which means it just is naturally more favorable to close the position as the profit on that spread grows that's because as a spread gets more and more profitable you can not only lose the profits you've made up to that point but you can also lose the initial loss potential when entering that trade and therefore you have lots more to lose and less to gain overall your risk grows and your reward potential diminishes the more profitable the vertical spread gets for instance if I buy a 10 dollar wide call spread for five dollars I have 500 to make and 500 to lose if the spreads value increases to $9 I would have a $4 profit on that spread and only one dollar left to make because with the spread at nine dollars and its maximum potential value of 10 dollars there's only one more dollar that that spread can gain and therefore I have nine dollars to lose since the spread is worth nine dollars and I have one dollar left to gain clearly the risk to reward ratio is much less favorable compared to when I entered the trade because when I entered the trade I had 500 to make and 500 to lose but since the spreads value increased to nine dollars I can lose 900 dollars but I can only make another hundred dollars and therefore it just seems very logical to close that trade since the spread is already worth ninety percent of its maximum value potential of ten dollars the opposite is true for losing vertical spreads for spreads that are unprofitable it becomes less and less logical to close the trade the larger the loss gets because since you can only lose so much when trading a vertical spread the closer the loss gets to the maximum loss potential the less you have to lose from that position because you've already lost a majority of it but you can still make back everything you've lost in addition to the initial profit potential which means holding that trade is almost like a lottery ticket since the damage is already done but you still have all of that profit potential and loss potential to get back even though it is probably unlikely at that point for example if I buy a 15 dollar wide spread for seven dollars the most I can lose is $700 per spread and the most I can gain is $800 per spread let's say that spreads price goes from seven dollars to two dollars in that scenario I would have a five dollar loss per spread and when I account for the option contract multiplier of 100 that gives me a 500 dollar loss per spread with the spreads value at two dollars the most I can lose is $200 per spread but if the spreads price miraculously goes from two dollars to its maximum value of 15 dollars through a favorable stock price movement I will experience a $1300 gain in my favor so initially if I buy the spread for seven dollars the most I can lose is $700 and the most I can gain is $800 however as the position becomes more and more unprofitable and as the spreads value gets closer to zero dollars I have less and less to lose since most of the damage is already done but I have more to therefore the more unprofitable a vertical spread position gets the less logical it becomes to close that spread since the risk to reward potential gets more favorable for you in the case of unprofitable vertical spreads I'm not suggesting that you should not take losses when trading vertical spreads if you do implement a loss taking strategy when trading vertical spreads choose a loss level that isn't so large that taking the trade off for a loss wouldn't make sense in the end it's never a bad decision to cut losses when trading options but in the case of vertical spreads there does come a point at which it's not as logical to do so from a risk to reward standpoint in terms of techniques that can be used to take off profitable and unprofitable vertical spread trades we can use profit percentages we can use loss percentages we can use time-based exits and we can also use Delta based exits let me go through each of these techniques individually so you can get a better idea of how you might implement each one of these strategies in whatever trading strategy you're currently following profit and loss percentages are very straightforward because you're simply closing the vertical spread at a particular profit percentage or a particular loss percentage Delta based exits would be to implement a strategy where you close your vertical spread trade when one of the options in your vertical spread reaches a certain Delta level for example let's say I have a call credit spread strategy and when I enter the trade my strategy is to sell the 40 Delta call option and purchase the 20 Delta call option to complete my call credit spread position an example of a delta based exit strategy would be to close this call credit spread if the short calls Delta reached 50 or 0.5 0 in other words the call spread position is closed if the short calls Delta increases from 40 to 50 which would be the case if the stock price increased by a certain margin using Delta based exit strategies is a great way to quantify exit points based on stock price movements as opposed to pure profit or loss levels on that particular spread finally a time-based exit strategy is to simply close the vertical spread after a certain amount of time in the trade for instance if I buy call spreads with 60 days until expiration an example of a time-based exit strategy would be to close that 60 day bread after I've been in the trade for 40 days no matter what the current profit or loss is at the time of exiting the trade after 40 days a time-based exit strategy is great for exiting trades that have not worked for you or against you in a significant manner after a certain amount of time has elapsed in that particular trade by doing so you can salvage value from trades that are partial losses and that haven't hit your worst case loss limit and you can also take partial profits on trades that are profitable but haven't yet hit your overall profit target more importantly using time-based exits saves you from holding positions all the way to expiration which can be a very good thing because the closer and option that is to its expiration date the more sensitive the options price changes will be relative to stock price changes that means that if you have a spread that is almost at your profit target but not quite there yet if that spread has very little time to expiration and the stock price changes directions and starts moving against your spread you could see that profitable position turn into an unprofitable position with a very small change in the stock price because those options have very little time until expiration and are therefore very sensitive to changes in the stock price in most cases having a very sensitive option position is not what you want and by implementing a time-based exit strategy you can smooth out the performance of your position over time and eliminate that volatility that happens when your option position is nearing its expiration date that's gonna do it for this video everybody I really hope you enjoyed this video on vertical spreads and that you feel much more comfortable with how they work some of the nuances that I've discussed that not many people talk about and also some strategies that you can start implementing and not only vertical spreads but any trading strategy that you ever follow if you have any questions or comments about this video please leave a comment down below as I'd love to hear from you if you enjoyed this video please give it a thumbs up and share it with your trading buddies don't forget to check the links down in the description for additional resources I'm Chris from Project option comm and I will see you in the next video [Music] [Applause] [Music] [Music] [Music]

Channel: projectfinance

Views: 91,879

Rating: 4.9103999 out of 5

Keywords: vertical spread options trading tips, vertical spread, vertical spread option trading, vertical spread options, vertical spreads, credit spread, debit spread, options trading, selecting strike prices vertical spreads, bull put spread, bull call spread, bear call spread, bear put spread, call spread, put spread, call vertical spread, put vertical spread, options trading strategies, projectoption, implied volatility

Id: ToWePPcIUhg

Length: 31min 4sec (1864 seconds)

Published: Wed Jul 03 2019