Spreading Your Risk - An Options Strategy

Less risk and bigger gains are why this strategy works so well.

Hey there! My name is Nate and I write for WOLF Financial. If you enjoy learning about trading, I guarantee you’ll also enjoy my newsletter A Trader’s Education, and more of my content on 𝕏 @tradernatehere. Thanks for reading!

This service is for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. These are my opinions and observations only. I am not a financial advisor.

There are two primary trading goals to keep in mind at all times.

You want to be able to manage risk and maximize potential returns.

Your portfolio starts to do great things when you focus on these two important aspects of trading.

There are great opportunities and a myriad of strategies to utilize to do both of these things when you start using options.

Specifically, utilizing vertical option spreads can be a game changer and that is why we are taking time this week to take a closer look.

What are Vertical Option Spreads?

First, let’s break down what a vertical option spread contract is.

In the world of trading and investing it is easy to get overwhelmed or intimidated by the lingo and complex sounding strategies available.

In reality, many of these approaches are simple and effective.

Using vertical option spreads is a great example.

A vertical option spread is a strategy that involves buying and selling two options of the same type (call or put), with the same expiration date, but at different strike prices.

The most common types of vertical spreads are the bull call spread and the bear put spread.

A bull call spread involves buying a call option at a certain strike price and selling another call option at a higher strike price.

This strategy is used when the expectation is for a moderate increase in the price of the underlying asset.

We can use NVDA, which reports earnings on Tuesday, as an example.

You may want to make a trade to capture an upside move following a positive earnings report.

Daily candles for NVDA

If you are considering call options, you might be buying the $510 strike call options expiring November 24th for roughly $12.50 each per Friday’s closing price.

This means that your break-even price for this trade at expiration will be when NVDA shares reach $522.50.

$510 strike + $12.50 cost = $522.50 break-even share price

If NVDA moves up quickly or beyond this price, the owner of the call option will start to see profits.

But what if there was a way to see even larger profits for the same move and with less cost per contract?

This is where the vertical spread strategy shines.

Let’s say that in addition to buying the $510 strike call option, you also sell the $520 strike call option with the same November 24th expiration date.

NVDA Call Option Contract Prices as of Friday’s close

Now your cost is offset by the cash collected from selling the $520 strike call option.

This has two major impacts to your trade!

First, instead of needing $12.50 per contract, you now only need to spend $3.75 per vertical call spread.

Buy: $510 strike price, cost $12.50

Sell: $520 strike price, collect $9.25

Total Cost Per Contract: $12.50 - $9.25 = $3.75

You have reduced the amount of risk by offsetting some of the cost with the sale of a higher priced call option.

It is only $3.75 to enter this trade, about 1/3 of the cost of buying calls alone.

Now let’s take a look at the returns if NVDA moves up to $522.50 by the expiration date.

Recall that buying calls alone required shares to reach $522.50 just to break even.

This is because the value of the option at expiration is equal to the value of the underlying share price less the cost of the option contract.

The calls with a $510 strike price sold for $12.50 each require a big move above $522.50 to see big gains.

Using the vertical spread option strategy outlined above, the same move up to $522.50 would create gains of more than 160%, a more than 2.5x trade.

As the underlying shares move up towards $522.50, the value of the vertical call spread also moves up to a maximum value of $10.00 per contract.

$520 strike price - $510 strike price = $10 max profit

Again, this is for the same move in the underlying shares AND with less up-front cost (only $3.75 vs $12.50).

This lower cost has a trade off, but it is one you might find acceptable.

Sticking with the NVDA example, by selling the higher strike call you are giving up any gains beyond the $520 strike price.

This seems like a decent trade off.

Buying the $510 calls alone would require shares to move much higher than the $522.50 price level to match the gains that can be had with the vertical call spread strategy.

Of course, NVDA shares could blast off to $540 per contract. If that happened the vertical call spread still hits max profits at $10.00 per contract.

But is this a bad thing? Take a closer look at the numbers.

If you had bought just the $510 strike calls for $12.50, they would be worth $30 per contract at expiration ($540 share price - $510 strike price).

In other words, using just the $510 strike call options you would make a smaller percentage gain of 140% at expiration if shares moved all the way to $540.

That is less than the percentage gain of using the vertical call spread!

This is why I like using vertical option spreads, especially when trading higher priced stocks and in highly volatile markets which can drive up the cost of options.

And if you are looking for a downside trade, there is a vertical spread option strategy for that too.

A bear put spread involves buying a put option at a certain strike price and selling another put option at a lower strike price.

It is effectively the same strategy but for the opposite direction and can be used when moderate price movement is expected.

Benefits of Using Vertical Option Spreads

1. Defined Risk: The maximum loss is limited to the net premium paid for the spread (plus any commissions). This makes it easier to manage risk and plan trades.

2. Lower Cost: Vertical spreads are typically cheaper than buying a single option because the premium received from the sold option offsets the premium paid for the bought option.

3. Profit in Various Market Conditions: Bull call spreads can profit from a rising market, while bear put spreads can profit from a falling market.

The defined risk and flexibility of the strategy makes vertical spreads a versatile tool in any trader's aresenal.

It is no doubt one of my favorite options strategies.

Risks of Using Vertical Option Spreads

While vertical spreads offer many benefits, they are not without risks.

That said, I like the trade off.

1. Limited Profit Potential: The maximum profit is capped at the difference between the strike prices, minus the net premium paid. If you have an overly bullish or bearish outlook, this cap on profits can be a disadvantage.

2. Dependence on Price Movement: As with any trading strategy using options, the underlying shares need to move enough to make the options trade profitable. Otherwise, you risk losing your investment completely.

3. Complexity: While not the most complex strategy, vertical spreads are more complex than simply buying a call or put. Understanding the profile of these trades will help you implement the strategy more effectively.

That is all for this week’s newsletter!

If you found this information helpful, consider sharing it with others and have a great week ahead!