#148 - Vertical Spread Example Plus Advantages & Disadvantages Of Trading Them

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Feb 17, 20184m
#148 - Vertical Spread Example Plus Advantages & Disadvantages Of Trading Them
Feb 17 '184m
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Hey everyone, Kirk here again from Option Alpha and welcome back to the daily call. Today, we are going to be talking about some vertical spread examples and also going through the advantages and disadvantages of trading spreads. First of all, what is a vertical spread? Well, there’s two types of vertical spreads generally. There are debit spreads and credit spreads. Debit spreads are when you are trading two different option contracts and the net result is that you end up paying a debit, so you’re paying to get into the position which means that you’re an option buyer. If you do a credit spread, that means you’re trading two different option contracts, but the net result is that you get paid a net premium or a net credit which means that you’re an option seller.

In either case though, they are still classified as vertical spreads because you're trading two different contracts. Where you can adjust your spreads is mostly on spread width, so how far out you end up selling the contracts or buying the contracts from one another. An example of a tight vertical spread might be if a stock is trading at $100. We might sell the 98 put options and buy the 97 put options. We would be a net credit seller in that case and we’d be doing a $1 wide spread. Now, if we wanted to do a wider spread, then what we would do is sell the 98 put options again, but then buy say the 95 put options as a $3 wide spread. Now, we’re doing the spread a little bit wider. There’s a lot of wiggle room obviously and you can do wider spreads or more narrow spreads as you keep going forward.

The main advantage to doing spreads is that you control your risk in those positions. That’s why I suggest it’s actually good for new traders, even if you're a little bit advanced. Still using spreads is not a bad idea. We use spreads all the time because we can control the risk. It has built-in risk management. And so, when you do a spread, you can never lose more than that spread differential in the contracts. You know exactly how much you can lose on a contract which means that you can control your position sizing really, really well and not get carried away with any margin calls or margin requirements.

The downside to then trading spreads as a generality is that because of this risk control, you do give up some of your premium. As we said earlier, if you're selling one option and buying another, that cost of buying the other option contract means that you’re going to make generally less money or have a little bit lower probability of success. Now, it’s not a huge difference and it depends on how wide you sell these contracts and still how far out of the money you buy or sell contracts, but that is the main thing that give up, is you give up a little bit of upside potential on that spread because you have to buy that insurance basically protection, that defined risk protection.

Ultimately though, you can do them really, really wide. That’s what we do a lot if we do an iron butterfly trade. We’ll do a wide iron butterfly where we’ll sell at the money contracts, but then buy our further out wings say $10 or even $12 out in some cases. They’re really, really cheap, so effectively, we’re buying very cheap insurance or protection in case the market continues to be volatile as it’s been over the last couple of weeks. Hopefully that helps out. As always, if you guys have any questions or comments, please let me know. Until next time, happy trading!

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