What is a vertical spread

A vertical spread is a type of options trading strategy that involves buying and selling options of the same class (either calls or puts) with the same expiration date but different strike prices. The goal is to profit from the difference in price between the options.

Vertical spreads offer a way to trade with defined risk and reward, making them a popular choice for traders looking to control their exposure and manage their positions more effectively. Today we are explicitly talking about debit vertical spreads.

Terminology

• Long strike: Strike price of the long option. This will be more in the money
• Short strike: Strike price of the short option. This will be more out of the money
• Implied volatility: Estimated volatility of the underlying asset's price, inferred from the market price of an option. It represents the market's view of the likelihood of price fluctuations over the life of the option.
• Skew: Change in implied volatility (IV) across different strike prices or expiration dates for options on the same underlying asset
• Delta: rate of change in an option’s price for a $1 change in the price of the underlying asset. It indicates how much the option’s price is expected to move when the underlying asset’s price changes.

1. Make sure skew is in your favor

Let's take a look at a sample option chain for AAPL

You will notice that the 5 dollar wide call spread circled is trading for $2.23 whereas the put spread on the other side with the same width and distance from the money is only trading for $1.69. This is because the long strike of the call spread has more implied volatility than the short strike whereas it is the opposite on the put side. You are buying high and selling low on the call side whereas the opposite on the put side. The put side of this trade has more favorable skew and better pricing.

2. Know your deltas

Delta for a vertical spread is crucial in trading because it helps traders understand how the position will react to changes in the price of the underlying asset. Here’s why delta is important for a vertical spread:

1. Directional Exposure: Delta measures the sensitivity of the vertical spread’s price to changes in the underlying asset’s price. By calculating the combined delta of the options in the spread, traders can gauge the overall directional exposure of the position. This helps in assessing how much the spread’s value will change with a move in the underlying asset, aiding in the decision-making process.

2. Profit and Loss Expectations: Delta helps in estimating potential profit or loss for a given price movement in the underlying asset. Understanding the delta of a vertical spread enables traders to predict how changes in the underlying price will impact the spread’s value, allowing them to set more informed profit targets and stop-loss levels.

3. Hedging and Adjustments: Traders often use delta to hedge their positions or adjust their portfolios. By understanding the delta of a vertical spread, traders can implement strategies to offset directional risk or adjust their exposure as market conditions change. For example, if a trader wants to reduce their overall market exposure, they can use delta to construct a hedge or modify the spread.

3. Use the front expirations to manage the position

Selling options in the front expirations to get credit back is a common strategy to reduce the overall debit in a trade, particularly when managing vertical spreads or other options positions.

Let's take an example. If you have a 5 dollar wide AAPL call spread that you paid $2.23 a contract to get into, you can check the delta of that position to be 0.15. That means that you can find any call less than 0.15 in a front expiration and sell it but still express your initial bias of being long AAPL. If you can get back $.30 back from the initial $2.23 debit outlay, you can drastically improve your risk to reward.

4. Use correlation with indices to find credit

If you think you are going long or short a market leader, you can find opportunities to sell options in the indices against support and resistance levels to take your initial debit down further.

Let's take for an example the same 5 dollar wide AAPL call spread. If you think AAPL is a market leader then it must outperform the overall index. Using the beta of AAPL to SPY, you can find a specific SPY delta option where the overall trade is still expressing your bias, but you think there are SPY options that are overpriced that you can sell to take down the initial debit of the trade

5. Use the option chain to simulate take profit and stop loss

One difficult part of options trading is that it is hard to estimate how much money you profit when you are right and how to set your stop loss. One way to do it is by looking at the existing option chain pricing and look at other options that are priced in real time to simulate the underlying making a chance in price.

For example, in the AAPL trade, it is currently trading at 226.49 and the 227.5/232.5 call spread is trading for $2.23. You think that AAPL is going to 236.49 but want to have a stop at 220. You can simulate the profit by moving down the option chain by 10 dollars. If AAPL were to move up 10 dollars, then the equivalent pricing would be for a 217.5/222.5 call option, which is currently trading for $4.08. If AAPL were to move down by 6.5, then the equivalent pricing would be for a 232.5/237.5 spread, which is $1.75. This shows that you have a very good risk reward if you follow your take profit and stop loss.

In summary, there are many ways to manage a simple vertical spread. The goal is always to improve your risk reward in a trade by understanding what it is, and find any way to improve it by selling options in front expirations or in correlated underlyings.