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Contents

Options Explained in Simple Words

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Profitable Options Trading Strategies For Trading Stock Options, Binary Options, Call & Put Using Technical Analysis

07:35:49 видео по запросу • Обновлено Март 2020

Basics Of Options Trading Explained

Before we delve deep into the world of options trading, let’s take a moment to understand why do we need options at all. If you are thinking it is just another way to make money and was created by some fancy guys in suits working in Wall Street, well, you are wrong. The options world predates the modern stock exchanges by a large margin.

While some credit the Samurai for giving us the foundation on which options contracts were based, some actually acknowledge the Greeks for giving us an idea on how to speculate on a commodity, in this case, the harvest of olives. In both cases, humans were trying to guess the price of a food item and trade accordingly (rice in the case of samurais), long before the modern world put in various rules and set up exchanges.

With this in mind, let us try to answer the first question in your mind.

What is options trading?

Let’s take a very simple example to understand options trading. Consider that you are buying a stock for Rs. 3000. But the broker tells you about an exciting offer, that you can buy it now for Rs. 3000 or you can give a token amount of Rs. 30 and reserve the right to buy it at Rs. 3000 after a month, even if the stock increases in value at that time. But that token amount is non-refundable!

You realise that there is a high chance that the stock would cross Rs. 3030 and thus, you can breakeven at least. Since you have to pay only Rs. 30 now, the remaining amount can be used elsewhere for a month. You wait for a month and then look at the stock price.

Now, depending on the stock price, you have the option to buy the stock from the broker or not. Of course, this is an over-simplification but this is options trading in a gist.In the world of trading, options are instruments that belong to the derivatives family, which means its price is derived from something else, mostly stocks. The price of an option is intrinsically linked to the price of the underlying stock.

A formal definition is given below:
A stock option is a contract between two parties in which the stock option buyer (holder) purchases the right (but not the obligation) to buy/sell shares of an underlying stock at a predetermined price from/to the option seller (writer) within a fixed period of time.

We are going to make sure that by the end of this article you are well versed with the options trading world along with trying out a few options trading strategies as well. We will cover the following points in this article. If you feel that you want to skip the basics of options, then head straight to the options trading strategies.

Let’s start now, shall we!

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Options trading vs. Stock trading

There must be a doubt in your mind that why do we even have options trading if it is just another way of trading. Well, here are a few points which make it different from trading stocks

  • The Options contract has an expiration date, unlike stocks. The expiration can vary from weeks, months to years depending upon the regulations and the type of Options that you are practising. Stocks, on the other hand, do not have an expiration date.
  • Unlike Stocks, Options derive their value from something else and that’s why they fall under the derivatives category
  • Options are not definite by numbers like Stocks
  • Options owners have no right (voting or dividend) in a company unlike Stock owners

It is quite often that some people find the Option’s concept difficult to understand though they have already followed it in their other transactions, for e.g. car insurance or mortgages. In this part of the article, we will take you through some of the most important aspects of Options trading before we get down to the world of options trading.

Options terminologies

Strike Price

The Strike Price is the price at which the underlying stocks can be bought or sold as per the contract. In options trading, the Strike Price for a Call Option indicates the price at which the Stock can be bought (on or before its expiration) and for Put Options trading it refers to the price at which the seller can exercise its right to sell the underlying stocks (on or before its expiration)

Premium

Since the Options themselves don’t have an underlying value, the Options premium is the price that you have to pay in order to purchase an Option. The premium is determined by multiple factors including the underlying stock price, volatility in the market and the days until the Option’s expiration. In options trading, choosing the premium is one of the most important components.

Underlying Asset

In options trading, the underlying asset can be stocks, futures, index, commodity or currency. The price of Options is derived from its underlying asset. For the purpose of this article, we will be considering the underlying asset as the stock. The Option of stock gives the right to buy or sell the stock at a specific price and date to the holder. Hence its all about the underlying asset or stocks when it comes to Stock in Options Trading.

Expiration Date

In options trading, all stock options have an expiration date. The expiration date is also the last date on which the Options holder can exercise the right to buy or sell the Options that are in holding. In Options Trading, the expiration of Options can vary from weeks to months to years depending upon the market and the regulations.

Options Style

There are two major types of Options that are practised in most of the options trading markets.

  • American Options which can be exercised anytime before its expiration date
  • European Options which can only be exercised on the day of its expiration

Moneyness (ITM, OTM & ATM)

It is very important to understand the Options Moneyness before you start trading in Stock Options. A lot of options trading strategies are played around the Moneyness of an Option.

It basically defines the relationship between the strike price of an Option and the current price of the underlying Stocks. We will examine each term in detail below.

When is an Option in-the-money?

  • Call Option – when the underlying stock price is higher than the strike price
  • Put Option – when the underlying stock price is lower than the strike price

When is an Option out-of-the-money?

  • Call Option – when the underlying stock price is lower than the strike price
  • Put Option – when the underlying stock price is higher than the strike price

When is an Option at-the-money?

  • When the underlying stock price is equal to the strike price.

Take a break here to ponder over the different terms as we will find it extremely useful later when we go through the types of options as well as a few options trading strategies.

Type of options

In the true sense, there are only two types of Options i.e Call & Put Options. We will understand them in more detail.

To Call or Put

A Call Option is an option to buy an underlying Stock on or before its expiration date. At the time of buying a Call Option, you pay a certain amount of premium to the seller which grants you the right (but not the obligation) to buy the underlying stock at a specified price (strike price).

Purchasing a call option means that you are bullish about the market and hoping that the price of the underlying stock may go up. In order for you to make a profit, the price of the stock should go higher than the strike price plus the premium of the call option that you have purchased before or at the time of its expiration.

In contrast, a Put Option is an option to sell an underlying Stock on or before its expiration date. Purchasing a Put Option means that you are bearish about the market and hoping that the price of the underlying stock may go down. In order for you to make a profit, the price of the stock should go down from the strike price plus the premium of the Put Option that you have purchased before or at the time of its expiration.

In this manner, both Put and Call option buyer’s loss is limited to the premium paid but profit is unlimited. The above explanations were from the buyer’s point of view. We will now understand the put-call options from the seller’s point of view, ie options writers. The Put option seller, in return for the premium charged, is obligated to buy the underlying asset at the strike price.

Similarly, the Call option seller, in return for the premium charged, is obligated to sell the underlying asset at the strike price. Is there a way to visualise the potential profit/loss of an option buyer or seller? Actually, there is. An option payoff diagram is a graphical representation of the net Profit/Loss made by the option buyers and sellers.

Before we go through the diagrams, let’s understand what the four terms mean. As we know that going short means selling and going long means buying the asset, the same principle applies to options. Keeping this in mind, we will go through the four terms.

  • Short call – Here we are betting that the prices will fall and hence, a short call means you are selling calls.
  • Short put – Here the short put means we are selling a put option
  • Long call – it means that we are buying a call option since we are optimistic about the underlying asset’s share price
  • Long put – Here we are buying a put option.

S = Underlying Price
X = Strike Price

Break-even point is that point at which you make no profit or no loss.

The long call holder makes a profit equal to the stock price at expiration minus strike price minus premium if the option is in the money. Call option holder makes a loss equal to the amount of premium if the option expires out of money and the writer of the option makes a flat profit equal to the option premium.

Similarly, for the put option buyer, profit is made when the option is in the money and is equal to the strike price minus the stock price at expiration minus premium. And, the put writer makes a profit equal to the premium for the option.

All right, until now we have been going through a lot of theory. Let’s switch gears for a minute and come to the real world. How do options look like? Well, let’s find out.

What does an options trading quote consist of?

If you were to look for an options quote on Apple stock, it would look something like this:

When this was recorded, the stock price of Apple Inc. was $196. Now let’s take one line from the list and break it down further.

Eg.

In a typical options chain, you will have a list of call and put options with different strike prices and corresponding premiums. The call option details are on the left and the put option details are on the right with the strike price in the middle.

  • The symbol and option number is the first column.
  • The “last” column signifies the amount at which the last time the option was bought.
  • Change” indicates the variance between the last two trades of the said options
  • Bid” column indicates the bid submitted for the option.
  • Ask” indicates the asking price sought by the option seller.
  • Volume” indicates the number of options traded. Here the volume is 0.
  • Open Interest” indicates the number of options which can be bought for that strike price.

The columns are the same for the put options as well. In some cases, the data provider signifies whether the option is in the money, at the money or out of money as well. Of course, we need an example to really help our understanding of options trading. Thus, let’s go through one now.

Options Trading Example

We will go through two cases to better understand the call and put options.

For simplicity’s sake, let us assume the following:

  • Price of Stock when the option is written: $100
  • Premium: $5
  • Expiration date: 1 month after the option is bought

Case 1:

The current price of stock: $110. Strike price: $120

Case 2:

The current price of stock: $120. Strike price: $110

Considering that we have gone through the detailed scenario of each option, how about we combine a few options together. Let’s understand an important concept which many professionals use in options trading.

What is Put-Call Parity In Python?

Put-call parity is a concept that anyone who is interested in options trading needs to understand. By gaining an understanding of put-call parity you can understand how the value of call option, put option and the stock are related to each other. This enables you to create other synthetic position using various option and stock combination.

The principle of put-call parity

Put-call parity principle defines the relationship between the price of a European Put option and European Call option, both having the same underlying asset, strike price and expiration date. If there is a deviation from put-call parity, then it would result in an arbitrage opportunity. Traders would take advantage of this opportunity to make riskless profits till the time the put-call parity is established again.

The put-call parity principle can be used to validate an option pricing model. If the option prices as computed by the model violate the put-call parity rule, such a model can be considered to be incorrect.

Understanding Put-Call Parity

To understand put-call parity, consider a portfolio “A” comprising of a call option and cash. The amount of cash held equals the call strike price. Consider another portfolio “B” comprising of a put option and the underlying asset.

S0 is the initial price of the underlying asset and ST is its price at expiration.
Let “r” be the risk-free rate and “T” be the time for expiration.
In time “T” the Zero-coupon bond will be worth K (strike price) given the risk-free rate of “r”.

Portfolio A = Call option + Zero-coupon bond

Portfolio B = Put option + Underlying Asset

If the share price is higher than X the call option will be exercised. Else, cash will be retained. Hence, at “T” portfolio A’s worth will be given by max(ST, X).

If the share price is lower than X, the put option will be exercised. Else, the underlying asset will be retained. Hence, at “T”, portfolio B’s worth will be given by max (ST, X).

If the two portfolios are equal at time, “T”, then they should be equal at any time. This gives us the put-call parity equation.

Equation for put-call parity:

C + Xe-rT = P + S0

In this equation,

  • C is the premium on European Call Option
  • P is the premium of European Put Option
  • S0 is the spot price of the underlying stock
  • And, Xe-rT is the current value (discounted value) of Zero-coupon bond (X)

We can summarize the payoffs of both the portfolios under different conditions as shown in the table below.

From the above table, we can see that under both scenarios, the payoffs from both the portfolios are equal.

Required Conditions For Put-call Parity

For put-call parity to hold, the following conditions should be met. However, in the real world, they hardly hold true and put-call parity equation may need some modifications accordingly. For the purpose of this blog, we have assumed that these conditions are met.

  • The underlying stock doesn’t pay any dividend during the life of the European options
  • There are no transaction costs
  • There are no taxes
  • Shorting is allowed and there are no borrow charges

Hence, put-call parity will hold in a frictionless market with the underlying stock paying no dividends.

Arbitrage Opportunity

In options trading, when the put-call parity principle gets violated, traders will try to take advantage of the arbitrage opportunity. An arbitrage trader will go long on the undervalued portfolio and short the overvalued portfolio to make a risk-free profit.

How to take advantage of arbitrage opportunity

Let us now consider an example with some numbers to see how trade can take advantage of arbitrage opportunities. Let’s assume that the spot price of a stock is $31, the risk-free interest rate is 10% per annum, the premium on three-month European call and put are $3 and $2.25 respectively and the exercise price is $30.

In this case, the value of portfolio A will be,

C+Xe-rT = 3+30e-0.1 * 3/12 = $32.26

The value of portfolio B will be,

P + S0 = 2.25 + 31 = $33.25

Portfolio B is overvalued and hence an arbitrageur can earn by going long on portfolio A and short on portfolio B. The following steps can be followed to earn arbitrage profits.

  • Short the stock. This will generate a cash inflow of $31.
  • Short the put option. This will generate a cash inflow of $2.25.
  • Purchase the call option. This will generate cash outflow of $3.
  • Total cash inflow is -3 + 2.25 + 31 = $30.25.
  • Invest $30.25 in a zero-coupon bond with 3 months maturity with a yield of 10% per annum.

Return from the zero coupon bond after three months will be 30.25e 0.1 * 3/12 = $31.02.

If the stock price at maturity is above $30, the call option will be exercised and if the stock price is less than $30, the put option will be exercised. In both the scenarios, the arbitrageur will buy one stock at $30. This stock will be used to cover the short.

Total profit from the arbitrage = $31.02 – $30 = $1.02

Well, shouldn’t we look at some codes now?

Python Codes Used For Plotting The Charts

The below code can be used to plot the payoffs of the portfolios.

So far, we have gone through the basic concepts in options trading and looked at an options trading strategy as well. At this juncture, let’s look at the world of options trading and try to answer a simple question.

Why is Options Trading attractive?

Options are attractive instruments to trade in because of the higher returns. An option gives the right to the holder to do something, with the ‘option’ of not to exercise that right. This way, the holder can restrict his losses and multiply his returns.

While it is true that one options contract is for 100 shares, it is thus less risky to pay the premium and not risk the total amount which would have to be used if we had bought the shares instead. Thus your risk exposure is significantly reduced.However, in reality, options trading is very complex and that is because options pricing models are quite mathematical and complex.

So, how can you evaluate if the option is really worth buying? Let’s find out.

The key requirement in successful options trading strategies involves understanding and implementing options pricing models. In this section, we will get a brief understanding of Greeks in options which will help in creating and understanding the pricing models.

Options Pricing

Options Pricing is based on two types of values

Intrinsic Value of an option

Recall the moneyness concept that we had gone through a few sections ago. When the call option stock price is above the strike price or when put option stock price is below the strike price, the option is said to be “In-The-Money (ITM)”, i.e. it has an intrinsic value. On the other hand, “Out of the money (OTM)” options have no intrinsic value. For OTM call options, the stock price is below the strike price and for OTM put options; stock price is above the strike price. The price of these options consists entirely of time value.

Time Value of an option

If you subtract the amount of intrinsic value from an options price, you’re left with the time value. It is based on the time to expiration. You can enroll for this free online options trading python course on Quantra and understand basic terminologies and concepts that will help you in options trading. We know what is intrinsic and the time value of an option. We even looked at the moneyness of an option. But how do we know that one option is better than the other, and how to measure the changes in option pricing. Well, let’s take the help of the greeks then.

Options Greeks

Greeks are the risk measures associated with various positions in options trading. The common ones are delta, gamma, theta and vega. With the change in prices or volatility of the underlying stock, you need to know how your options pricing would be affected. Greeks in options help us understand how the various factors such as prices, time to expiry, volatility affect the options pricing.

Delta measures the sensitivity of an option’s price to a change in the price of the underlying stock. Simply put, delta is that options greek which tells you how much money a stock option will rise or drop in value with a $1 rise or drop in the underlying stock. Delta is dependent on underlying price, time to expiry and volatility. While the formula for calculating delta is on the basis of the Black-Scholes option pricing model, we can write it simply as,

Delta = [Expected change in Premium] / [Change in the price of the underlying stock]

Let’s understand this with an example for a call option:
We will create a table of historical prices to use as sample data. Let’s assume that the option will expire on 5th March and the strike price agreed upon is $140.

Thus, if we had to calculate the delta for the option on 2nd March, it would be $5/$10 = 0.5.

Here, we should add that since an option derives its value from the underlying stock, the delta option value will be between 0 and 1. Usually, the delta options creeps towards 1 as the option moves towards “in-the-money”.

While the delta for a call option increases as the price increases, it is the inverse for a put option. Think about it, as the stock price approaches the strike price, the value of the option would decrease. Thus, the delta put option is always ranging between -0 and 1.

Gamma measures the exposure of the options delta to the movement of the underlying stock price. Just like delta is the rate of change of options price with respect to underlying stock’s price; gamma is the rate of change of delta with respect to underlying stock’s price. Hence, gamma is called the second-order derivative.

Gamma = [Change in an options delta] / [Unit change in price of underlying asset]

Let’s see an example of how delta changes with respect to Gamma. Consider a call option of stock at a strike price of $300 for a premium of $15.

  • Strike price: $300
  • Initial Stock price: $150
  • Delta: 0.2
  • Gamma: 0.005
  • Premium: $15
  • New stock price: $180
  • Change in stock price: $180 – $150 = $30

Thus, Change in Premium = Delta * Change in price of stock = 0.2 * 30 = 6.
Thus, new premium = $15 + $6 = $21

Change in delta = Gamma * Change in stock price = 0.005 * 30 = 0.15
Thus, new delta = 0.2 + 0.15 = 0.35.

Let us take things a step further and assume the stock price increases another 30 points, to $210.

Now,
New stock price: $210
Change in stock price: $210 – $180 = $30

Change in premium = Delta *Change in 0.35*30 = $10.5
Thus, new premium = $21 + $10.5 = $31.5

Change in delta = Gamma * Change in stock price = 0.005 * 30 = 0.15
Thus, new delta = 0.35 + 0.15 = 0.5.

In this way, delta and gamma of an option changes with the change in the stock price. We should note that Gamma is the highest for a stock call option when the delta of an option is at the money. Since a slight change in the underlying stock leads to a dramatic increase in the delta. Similarly, the gamma is low for options which are either out of the money or in the money as the delta of stock changes marginally with changes in the stock option.

Highest Gamma for At-the-money (ATM) option
Among the three instruments, at-the-money (ATM), out-of-the-money (OTM) and in-the-money (ITM); at the money (ATM) has the highest gamma. You can watch this video to understand it in more detail.

Theta measures the exposure of the options price to the passage of time. It measures the rate at which options price, especially in terms of the time value, changes or decreases as the time to expiry is approached.

Vega measures the exposure of the option price to changes in the volatility of the underlying. Generally, options are more expensive for higher volatility. So, if the volatility goes up, the price of the option might go up to and vice-versa.

Vega increases or decreases with respect to the time to expiry?

What do you think? You can confirm your answer by watching this video.

One of the popular options pricing model is Black Scholes, which helps us to understand the options greeks of an option.

Black-Scholes options pricing model

The formula for the Black-Scholes options pricing model is given as:

C is the price of the call option
P represents the price of a put option.
S0 is the underlying price,
X is the strike price,
σ represents volatility,
r is the continuously compounded risk-free interest rate,
t is the time to expiration, and
q is the continuously compounded dividend yield.
N(x) is the standard normal cumulative distribution function.

The formulas for d1 and d2 are given as:

To calculate the Greeks in options we use the Black-Scholes options pricing model.

Delta and Gamma are calculated as:

In the example below, we have used the determinants of the BS model to compute the Greeks in options.

At an underlying price of 1615.45, the price of a call option is 21.6332.

If we were to increase the price of the underlying by Rs. 1, the change in the price of the call, put and values of the Greeks in the option is as given below.

As can be observed, the Delta of the call option in the first table was 0.5579. Hence, given the definition of the delta, we can expect the price of the call option to increase approximately by this value when the price of the underlying increases by Rs.1. The new price of the call option is 22.1954 which is

22.1954
22.1911

Let’s move to Gamma, another Greek in option.

If you observe the value of Gamma in both the tables, it is the same for both call and put options contracts since it has the same formula for both options types. If you are going long on the options, then you would prefer having a higher gamma and if you are short, then you would be looking for a low gamma. Thus, if an options trader is having a net-long options position then he will aim to maximize the gamma, whereas in case of a net-short position he will try to minimize the gamma value.

The third Greek, Theta has different formulas for both call and put options. These are given below:

In the first table on the LHS, there are 30 days remaining for the options contract to expire. We have a negative theta value of -0.4975 for a long call option position which means that the options trader is running against time.

He has to be sure about his analysis in order to profit from trade as time decay will affect this position. This impact of time decay is evident in the table on the RHS where the time left to expiry is now 21 days with other factors remaining the same. As a result, the value of the call option has fallen from 21.6332 to 16.9 behaviour 319. If an options trader wants to profit from the time decay property, he can sell options instead of going long which will result in a positive theta.

We have just discussed how some of the individual Greeks in options impact option pricing. However, it is very essential to understand the combined behaviour of Greeks in an options position to truly profit from your options position. If you want to work on options greeks in Excel, you can refer to this blog.

Let us now look at a Python package which is used to implement the Black Scholes Model.

Python Library – Mibian

What is Mibian?

Mibian is an options pricing Python library implementing the Black-Scholes along with a couple other models for European options on currencies and stocks. In the context of this article, we are going to look at the Black-Scholes part of this library. Mibian is compatible with python 2.7 and 3.x. This library requires scipy to work properly.

How to use Mibian for BS Model?

The function which builds the Black-Scholes model in this library is the BS() function. The syntax for this function is as follows:

The first input is a list containing the underlying price, strike price, interest rate and days to expiration. This list has to be specified each time the function is being called. Next, we input the volatility, if we are interested in computing the price of options and the option greeks. The BS function will only contain two arguments.

If we are interested in computing the implied volatility, we will not input the volatility but instead will input either the call price or the put price. In case we are interested in computing the put-call parity, we will enter both the put price and call price after the list. The value returned would be:

(call price + price of the bond worth the strike price at maturity) – (put price + underlying asset price)

The syntax for returning the various desired outputs are mentioned below along with the usage of the BS function. The syntax for BS function with the input as volatility along with the list storing underlying price, strike price, interest rate and days to expiration:

Attributes of the returned value from the above-mentioned BS function:

The syntax for BS function with the input as callPrice along with the list storing underlying price, strike price, interest rate and days to expiration:

Attributes of the returned value from the above-mentioned BS function:

The syntax for BS function with the input as putPrice along with the list storing underlying price, strike price, interest rate and days to expiration:

Attributes of the returned value from the above-mentioned BS function:

The syntax for BS function with the inputs as callPrice and putPrice along with the list storing underlying price, strike price, interest rate and days to expiration:

Attributes of the returned value from the above-mentioned BS function:

While Black-Scholes is a relatively robust model, one of its shortcomings is its inability to predict the volatility smile. We will learn more about this as we move to the next pricing model.

Derman Kani Model

The Derman Kani model was developed to overcome the long-standing issue with the Black Scholes model, which is the volatility smile. One of the underlying assumptions of Black Scholes model is that the underlying follows a random walk with constant volatility. However, on calculating the implied volatility for different strikes, it is seen that the volatility curve is not a constant straight line as we would expect, but instead has the shape of a smile. This curve of implied volatility against the strike price is known as the volatility smile.

If the Black Scholes model is correct, it would mean that the underlying follows a lognormal distribution and the implied volatility curve would have been flat, but a volatility smile indicates that traders are implicitly attributing a unique non-lognormal distribution to the underlying. This non-lognormal distribution can be attributed to the underlying following a modified random walk, in the sense that the volatility is not constant and changes with both stock price and time. In order to correctly value the options, we would need to know the exact form of the modified random walk.

The Derman Kani model shows how to take the implied volatilities as inputs to deduce the form of the underlying’s random walk. More specifically a unique binomial tree is extracted from the smile corresponding to the random walk of the underlying, this tree is called the implied tree. This tree can be used to value other derivatives whose prices are not readily available from the market – for example, it can be used in standard but illiquid European options, American options, and exotic options.

What is the Heston Model?

Steven Heston provided a closed-form solution for the price of a European call option on an asset with stochastic volatility. This model was also developed to take into consideration the volatility smile, which could not be explained using the Black Scholes model.

The basic assumption of the Heston model is that volatility is a random variable. Therefore there are two random variables, one for the underlying and one for the volatility. Generally, when the variance of the underlying has been made stochastic, closed-form solutions will no longer exist.

But this is a major advantage of the Heston model, that closed-form solutions do exist for European plain vanilla options. This feature also makes calibration of the model feasible. If you are interested in learning about these models in more detail, you may go through the following research papers,

  • Derman Kani Model – “The Volatility Smile and Its Implied Tree” by Emanuel Derman and Iraj Kani.
  • Heston Model – “A Closed-Form Solution for Options with Stochastic Volatility with Applications to Bond and Currency Options”

So far, you have understood options trading and how to analyse an option as well as the pricing models used. Now, to apply this knowledge, you will need access to the markets, and this is where the role of a broker comes in.

Opening an options trading account

How to choose a broker for Options Trading?

Before we open an options trading account with a broker, let’s go over a few points to take into consideration when we choose a broker.

  • Understand your aim when you tread the options trading waters, whether it is a way of hedging risk, as a speculative instrument, for income generation etc.
  • Does the broker provide option evaluation tools of their own? It is always beneficial to have access to a plethora of tools when you are selecting the right option.
  • Enquire the transaction costs or the commission charged by the broker as this will eat into your investment gains.
  • Some brokers give access to research materials in various areas of the stock market. You can always check with the broker about access to research as well as subscriptions etc.
  • Check the payment options provided by the broker to make sure it is compatible with your convenience.

Searching for the right broker

Once the required background research is done, you can choose the right broker as per your need and convenience. In the global market, a list of the top brokers is provided below:

List of Top International Brokers (Options Trading)

The list of top international options brokers is given below:

  • E-trade ($0.65 per options contract)
  • Ally Invest ($0.5 per contract traded)
  • TD Ameritrade ($0.65 fee per contract)
  • Interactive Brokers (starts at $0.25 per options contract)
  • Schwab Brokerage ($0.65 per options contract)

List of Top Indian Brokers (Options Trading)

The list of top Indian options brokers is given below:

  • Zerodha
  • ICICI Direct
  • HDFC Securites
  • ShareKhan
  • Kotak Securities
  • Angel Broking
  • Axis Direct

Great! Now we look at some options trading strategies which can be used in the real world.

Options Trading Strategies

There are quite a few options trading strategies which can be used in today’s trading landscape. One of the most popular options trading strategies is based on Spreads and Butterflies. Let’s look at them in detail.

Spreads and Butterflies

Spreads or rather spread trading is simultaneously buying and selling the same option class but with different expiration date and strike price. Spread options trading is used to limit the risk but on the other hand, it also limits the reward for the person who indulges in spread trading.

Thus, if we are only interested in buying and selling call options of security, we will call it a call spread, and if it is only puts, then it will be called a put spread.

Depending on the changing factor, spreads can be categorised as:

  • Horizontal Spread – Different expiration date, Same Strike price
  • Vertical Spread – Same Expiration date, Different Strike price
  • Diagonal Spread – Different expiration date, Different Strike price

Remember that an option’s value is based on the underlying security (in this case, stock price). Thus, we can also distinguish an option spread on whether we want the price to go up (Bull spread) or go down (Bear spread).

Bull call spread

In a bull call spread, we buy more than one option to offset the potential loss if the trade does not go our way.

Let’s try to understand this with the help of an example.
The following is a table of the available options for the same underlying stock and same expiry date:

Normally, if we have done the analysis and think that the stock can rise to $200, one way would be to buy a call stock option with a strike price of $180 for a premium of $15. Thus, if we are right and the stock reaches $200 on expiry, we buy it at the strike price of $180 and pocket a profit of ($20 -$15) = $5 since we paid the premium of $15.

But if we were not right and the stock price reaches $180 or less, we will not exercise the option resulting in a loss of the premium of $15. One workaround is to buy a call option at $180 and sell a call option for $200 at $10.

Thus, when the stock’s price reaches $200 on expiry, we exercise the call option for a profit of $5 (as seen above) and also pocket a profit of the premium of $10 since it will not be exercised by the owner. Thus, in this way, the total profit is ($5 + $10) = $15.

If the stock price goes above $200 and the put option is exercised by the owner, the increase in the profit from bought call option at $180 will be the same as the loss accumulated from the sold call option at $200 and thus, the profit would always be $15 no matter the increase in the stock price above $200 at expiry date.

Let’s construct a table to understand the various scenarios.

You can go through this informative blog to understand how to implement it in Python.

Bear put spread

The bull call spread was executed when we thought the stock would be increasing, but what if we analyse and find the stock price would decrease. In that case, we use the bear put spread.

Let’s assume that we are looking at the different strike prices of the same stock with the same expiry date.

One way to go about it is to buy the put option for the strike price of 160 at a premium of $15 while selling a put option for the strike price of $140 for the strike price of $10.

Thus, we create a scenario table as follows:

In this way, we can minimize our losses by simultaneously buying and selling options. You can go through this informative blog to understand how to implement it in Python.

Butterfly Spread

A butterfly spread is actually a combination of bull and bear spreads. One example of the Butterfly Options Strategy consists of a Body (the middle double option position) and Wings (2 opposite end positions).

  • Its properties are listed as follows:
  • It is a three-leg strategy
  • Involves buying or selling of Call/Put options (unlike Covered Call Strategy where a stock is bought and an OTM call option is sold)
  • Can be constructed using Calls or Puts
  • 4 options contracts at the same expiry date
  • Have the same underlying asset
  • 3 different Strike Prices are involved (2 have the same strike price)
  • Create 2 Trades with these calls

Other Trading Strategies

We will list down a few more options trading strategies below:

Summary

We have covered all the basics of options trading which include the different Option terminologies as well as types. We also went through an options trading example and the option greeks. We understood various options trading strategies and things to consider before opening an options trading account.

If you have always been interested in automated trading and don’t know where to start, we have created a learning track for you at Quantra, which includes the. “Trading using Option Sentiment Indicators” course.

Disclaimer: All data and information provided in this article are for informational purposes only. QuantInsti ® makes no representations as to accuracy, completeness, currentness, suitability, or validity of any information in this article and will not be liable for any errors, omissions, or delays in this information or any losses, injuries, or damages arising from its display or use. All information is provided on an as-is basis.

Vertical Spreads Explained: The Ultimate Guide

Vertical spreads are the most basic options strategies that serve as the building blocks for more complex strategies.

Traders can use vertical spread options strategies to profit from stock price increases, decreases, or even sideways movements in the share price.

In this comprehensive guide, we’ll cover everything you need to know about trading verticals.

What is a Vertical Spread?

A vertical spread is an options strategy constructed by simultaneously buying an option and selling an option of the same type and expiration date, but different strike prices. A call vertical spread consists of buying and selling call options at different strike prices in the same expiration, while a put vertical spread consists of buying and selling put options at different strike prices in the same expiration. Vertical spreads can be bullish or bearish.

Consider the following example:

June 2020 Call Options

Strike Price

Buy/Sell

Quantity

Buy

Sell

In the above example, a trader is buying one contract of the 150 call while also selling one contract of the 175 call. Both call options are in the June 2020 expiration cycle.

The trade is considered a call vertical spread because the trader is buying and selling call options that are in the same expiration cycle but have different strike prices.

Vertical Spread

A category of options strategies that are constructed with two options at different strike prices in the same expiration cycle. One option is purchased and the other option is sold.

In the next sections of this guide, we’ll cover the four types of vertical spreads:

The Bull Call Spread

The Bear Call Spread

The Bear Put Spread

The Bull Put Spread

We’ll show you how to set them up and when to trade them, as well as look at some expiration payoff diagrams and performance visualizations of real trade examples.

In the following examples, we’ll start by focusing on the directional aspect of each strategy. After covering each of the strategies, we’ll discuss more advanced topics such as how time decay and implied volatility play a role in the profitability of each strategy.

The Bull Call Spread Strategy

The bull call spread is, you guessed it, a bullish vertical spread constructed with call options. Bull call spreads are also commonly referred to as long call spreads, call debit spreads, or simply buying call spreads.

For a quick explanation of the strategy, check out Investopedia’s guide here.

In this guide, we’ll cover the strategy in great detail. Let’s start with the strategy’s basic characteristics:

How to Set Up the Trade

Buy a call option and simultaneously sell another call option at a higher strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bull call spreads make money when the share price increases, as the call spread’s value rises with the share price (all else being equal). Ideally, the stock price rises to the short call’s strike price by expiration.

When to Buy Call Spreads

Traders buy call spreads when they believe a stock’s price will increase, but not necessarily to a price higher than the strike price of the call that is sold.

Breakeven & Profit/Loss Potential

Breakeven Price = Long Call’s Strike Price + Premium Paid

Maximum Profit Potential = (Spread Width – Premium Paid) x $100*

Maximum Loss Potential = Premium Paid x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

To fully understand the strategy’s characteristics mentioned above, let’s walk through a real long call spread example using Facebook (FB) options from 2020.

Bull Call Spread Example

Here are the details of the bull call spread we’re going to analyze:

Stock Price at Entry: $142.28

Call Strikes & Prices: Buy the 135 Call for $9.30; Sell the 150 Call for $1.54; Both options expire in 46 days.

Spread Entry Price: $9.30 Paid – $1.54 Received = $7.76 Premium Paid

Breakeven Price: $135 Long Call Strike + $7.76 Premium Paid = $142.76

Maximum Profit Potential: ($15 Spread Width – $7.76 Premium Paid) x $100 = $724

Maximum Loss Potential: $7.76 Premium Paid x $100 = $776

Let’s hammer these points home by visualizing the position’s expiration payoff diagram:

Now, to make sure you understand these expiration profits/losses, let’s walk through each important price zone for this specific bull call spread position:

Maximum Profit Potential

Stock Price(s): At or above the short call’s strike price of $150.

Why?: At any price equal to or above $150, the 135 call will be worth $15 more than the 150 call at expiration. Therefore, the 135/150 call spread will be worth $15, translating to a $7.24 gain per spread ($724 profit per spread) since the initial purchase price was $7.76.

Breakeven

Stock Price(s): $142.76 at expiration.

Why?: At $142.76, the long 135 call will be worth $7.76 at expiration, while the short 150 call will expire worthless. As a result, the 135/150 call spread will be worth $7.76, which is the same as the initial purchase price.

Maximum Loss Potential

Stock Price(s): At or below the long call’s strike price of $135.

Why?: At any price below $135 at expiration, the 135 call and the 150 call will both expire worthless since they will be out-of-the-money. As a result, the net value of the 135/150 call spread will be $0.00, which translates to a $7.76 loss per spread ($776 in actual losses per spread) because the spreads were purchased for $7.76.

How Did the Trade Actually Perform?

The expiration payoff graph only tells us part of the story.

The spread’s value (and therefore the profits and losses on the trade) will fluctuate as the share price changes on a daily basis.

With that said, let’s take a look at what happened to this FB call spread as the share price changed between the entry date of the trade and the spread’s expiration date:

In the first few days of this trade, FB shares fell, resulting in small losses on the long 135/150 call spread.

Fortunately, the price of the stock surged higher, which resulted in an increase in the call spread’s value (and therefore profits for the buyer of the spread).

At expiration, the share price was at $148.06, which resulted in a net profit of $530 per call spread.

With FB shares at $148.06 at the time of expiration, the long 135 call expired to a value of $13.06 ($148.06 Stock Price – $135 Long Call Strike), while the short 150 call expired worthless. As a result, the net value of the long 135/150 call spread at expiration is $13.06.

Net P/L: ($13.06 Expiration Value – $7.76 Premium Paid) x $100 = +$530 per spread .

Bull Call Spread

A bullish call spread constructed by purchasing a call option and selling another call option at a higher strike price (same expiration cycle). The maximum profit occurs when the share price is equal to or above the short call’s strike price at expiration, while the maximum loss occurs when the stock price is below the long call’s strike price at expiration.

In short, traders who buy call spreads want the share price to rise, ideally to a price equal to or greater than the short call’s strike price by expiration.

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The Bear Call Spread Strategy

The bear call spread is a bearish vertical spread strategy constructed with two call options in the same expiration cycle. The strategy is also commonly referred to as a short call spread, call credit spread, or simply selling a call spread. Read Investopedia’s quick guide on the bear call spread strategy.

When you sell a call spread, you’re betting against an increase in the price of the stock.

Here are the strategy’s general characteristics:

How to Set Up the Trade

Sell a call option and simultaneously buy another call option at a higher strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bear call spreads make money when the share price decreases (since call prices fall when the share price decreases, all else equal), or as time passes with the share price below the breakeven price.

When to Sell Call Spreads

Traders sell call spreads when they believe a stock’s price will decrease or trade sideways through the expiration date of the spread.

Breakeven & Profit/Loss Potential

Breakeven Price = Short Call’s Strike Price + Premium Paid

Maximum Profit Potential = Premium Received x $100*

Maximum Loss Potential = (Spread Width – Premium Received) x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

Let’s take a look at some visuals so you can better understand the metrics from the table above!

Bear Call Spread Example

For our bear call spread example, we’ll turn to real option data in Apple (AAPL) from 2020.

Here are the specific details of the trade we’ll visualize:

Stock Price at Entry: $141.46

Call Strikes & Prices: Sell the 142 Call for $1.93; Buy the 145 Call for $0.87; Both options expire in 32 days.

Spread Entry Price: $1.93 Received – $0.87 Paid = $1.06 Received

Breakeven Price: $142 Short Call Strike + $1.06 Premium Received = $143.06

Maximum Profit Potential: $1.06 Premium Received x $100 = $106

Maximum Loss Potential: ($3 Spread Width – $1.06 Premium Received) x $100 = $194

Tables are cool, but nothing beats a nice expiration payoff graph to visually represent an option strategy’s profit and loss potential:

Maximum Profit Potential

Stock Price(s): At or below the short call’s strike price of $142.

Why?: At any price equal to or below $142, the 142 call and 145 call will both expire worthless. As a result, the net value of the 142/145 call spread will be $0.00, which translates to a $1.06 gain per spread ($106 in actual profits per spread) because the call spreads were initially sold for $1.06.

Breakeven

Stock Price(s): $143.06 at expiration.

Why?: At $143.06, the short 142 call will be worth $1.06, while the 145 call will expire worthless. As a result, the net value of the 142/145 call spread will be $1.06, which is the same price the spread was sold for initially.

Maximum Loss Potential

Stock Price(s): At or above the long call’s strike price of $145.

Why?: At any price equal to or above the long call’s strike price of $145 at expiration, the short 142 call will be worth $3.00 more than the long 145 call. As a result, the 142/145 call spread will be worth $3.00. With an initial sale price of $1.06, the loss per spread is $1.94 ($194 in actual losses per spread).

How Did the Trade Actually Perform?

Ok, now that we’ve discussed the potential outcomes for this AAPL call spread at expiration, let’s see what actually happened to the position over time:

At the time of entering the short 142/145 call spread, AAPL shares were trading just over $141.

Shortly after selling the call spread, AAPL shares surged higher to $145, which means the short call spread was almost entirely in-the-money (ITM).

As a result, the price of the call spread increased, which translated to losses for any traders who had sold that spread for $1.06.

Fortunately, AAPL headed lower and was trading for $142.06 per share at the time of the call spread’s expiration date. At $142.26, the short 142 call was worth $0.26 while the long 145 call expired worthless.

The end result? The short 142/145 call spread is worth $0.26 at expiration, translating to $80 in profits for any trader who initially sold the spread for $1.06:

Net P/L: ($1.06 Spread Sale Price – $0.26 Spread Expiration Price) x $100 Option Contract Multiplier = +$80 Profit Per Spread.

Bear Call Spread

A bearish call spread constructed by selling a call option while simultaneously buying another call option at a higher strike price (same expiration cycle).

The maximum profit potential is realized when the share price is below the short call’s strike price at expiration, while the maximum loss potential is realized when the share price is above the long call’s strike price at expiration.

In short, sellers of call spreads want the share price to fall or trade sideways as time passes, as both of these events will lead to a decrease in the price of the spread, and therefore profits for the call spread seller.

For more on this options strategy, be sure to check out our ultimate guide on the bear call spread strategy.

Congratulations! You’ve just learned the two call spread strategies! Both of these strategies will always have a place in your options trading arsenal.

In the next two sections, we’ll walk through both of the put spread strategies.

The Bear Put Spread Strategy

The bear put spread is a vertical spread options strategy used by traders who believe a stock’s price will fall (they’re bearish). The position consists of buying a put option while also selling another put option at a lower strike price in the same expiration.

When a trader buys a put spread, they’re betting the stock price will decrease.

Bear put spreads are also commonly referred to as long put spreads, put debit spreads, or simply buying a put spread. For a quick run-down of the strategy, check out Investopedia’s concise guide on the bear put spread.

In this guide, we’re going to cover every detail you need to know about the strategy. Let’s start by looking at the strategy’s general characteristics and then hop into some trade examples:

How to Set Up the Trade

Buy a put option and simultaneously sell another put option at a lower strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bear put spreads make money when the stock price falls (since the put spread’s value will increase), all else being equal.

When to Buy Put Spreads

Traders buy put spreads when they believe a stock’s price will fall, but not necessarily to a price lower than the short put’s strike price.

Breakeven & Profit/Loss Potential

Breakeven Price = Long Put’s Strike Price – Premium Paid

Maximum Profit Potential = (Spread Width – Premium Paid) x $100*

Maximum Loss Potential = Premium Paid x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

Let’s check out a long put vertical in AMZN from 2020.

Bear Put Spread Example

Here are the trade details of our particular bearish put spread:

Stock Price at Entry: $780.22

Put Strikes & Prices: Buy the 800 Put for $44.88; Sell the 750 Put for $22.63; Both options expire in 59 days.

Spread Entry Price: $44.88 Paid – $22.63 Received = $22.25 Paid

Breakeven Price: $800 Long Put Strike Price – $22.25 Premium Paid = $777.75

Maximum Profit Potential: ($50 Spread Width – $22.25 Premium Paid) x $100 = $2,775

Maximum Loss Potential: $22.25 Premium Paid x $100 = $2,225

In this example, AMZN shares are at $780.22 when a trader buys the 800 / 750 put spread expiring in November of 2020.

The spread will be maximally profitable if AMZN shares are below the short put’s strike price of $750 at expiration.

Conversely, the trader will lose the entire premium paid if AMZN shares are above the long put’s strike price of $800 at expiration:

Let’s dive into the specifics of why these expiration profits/losses are the way they are:

Maximum Profit Potential

Stock Price(s): At or below the short put’s strike price of $750.

Why?: At any price equal to or below $750, the 800 put will be worth $50 more than the 750 put at expiration, which means the 800/750 put spread will be worth $50. With an initial purchase price of $22.25, the gain per spread is $27.75 ($2,775 in actual profits per spread).

Breakeven

Stock Price(s): $777.75 at expiration.

Why?: At $777.75, the long 800 put will be worth $22.25, while the short 750 put will expire worthless. As a result, the net value of the 800/750 put spread will be $22.25, which is the same price the spread was purchased for initially.

Maximum Loss Potential

Stock Price(s): At or above the long put’s strike price of $800.

Why?: At any price above $800 at expiration, the 800 put and the 750 put will both expire worthless since they will be out-of-the-money. As a result, the net value of the 800/750 put spread will be $0.00, which translates to a $22.25 loss per spread (a loss of $2,225 per spread in actual losses) because the spreads were purchased for $22.25.

How Did the Trade Actually Perform?

Alright, we’ve gone through the potential outcomes at expiration, but what about when AMZN shares fluctuation over time?

Here’s how this put vertical spread performed over time:

Ouch! At first, AMZN shares rallied from around $780 all the way up to $850, which translated to losses for the long put spread trader as the spread lost value.

At one point, the 800 / 750 put spread’s price fell to $10, which represents a $1,225 loss per spread for the trader who purchased the spread for $22.25:

($10 Spread Value – $22.25 Purchase Price) x $100 Option Contract Multiplier = -$1,225 .

Fortunately, with AMZN shares trading for $760.16 at expiration, the long 800 put was worth $39.84 ($800 Put Strike Price – $760.16 Stock Price), while the short 750 put expired worthless.

As a result, the final value of the long 800 / 750 put spread is $39.84, which translates to a $17.59 profit per spread (in option terms):

$39.84 Spread Expiration Value – $22.25 Spread Purchase Price = $17.59 Spread Profit.

$17.59 Profit Per Spread x $100 Option Contract Multiplier = +$1,759 Total Profit.

Bear Put Spread

A bearish put spread constructed by buying a put option while simultaneously selling another put option at a lower strike price (same expiration cycle).

The maximum profit potential is realized when the stock price is below the short put’s strike price at expiration, while the maximum loss potential is realized when the stock price is above the long put’s strike price at expiration.

In short, buyers of put spreads want the stock price to fall to a price equal to or greater than the short put’s strike price, as the put spread’s price will approach its maximum potential value.

The Bull Put Spread Strategy

We’ve covered a ton of content already, but we’ve still got one more strategy to discuss before moving on.

The bull put spread strategy is a bullish vertical spread constructed by selling a put option while also buying another put option at a lower strike price in the same expiration.

You may also hear traders refer to the bull put spread strategy as a short put spread, put credit spread, or simply selling a put spread.

For a quick explanation of the strategy, be sure to take a look at Investopedia’s concise guide on the bull put spread.

In this guide, we’re going to cover the strategy in detail. Let’s take a look at the strategy’s general characteristics and then dive into a real trade example in Netflix (NFLX):

How to Set Up the Trade

Sell a put option and simultaneously buy another put option at a lower strike price. Both options need to be in the same expiration cycle.

How the Strategy Profits

Bull put spreads make money when the stock price increases (since the put spread’s value will fall, all else equal), or as time passes with the stock price above the strike price of the put that is sold.

When to Sell Put Spreads

Traders sell put spreads when they believe a stock’s price will rise or trade sideways through the expiration date of the put spread.

Breakeven & Profit/Loss Potential

Breakeven Price = Short Put’s Strike Price – Premium Received

Maximum Profit Potential = Premium Received x $100*

Maximum Loss Potential = (Strike Width – Premium Received) x $100*

*These calculations assume the options are standard equity options with a contract multiplier of $100. If the traded options have a contract multiplier different from $100, swap out $100 for the correct multiplier.

Let’s visualize this table by looking at an expiration payoff diagram and trade performance visualization of a real short put spread in NFLX.

Bull Put Spread Example

In the following example, we’ll examine a short put spread in NFLX that experiences both profits and losses over the duration of the trade.

Here are the specific trade details:

Stock Price at Entry: $146.92

Put Strikes & Prices: Sell the 145 Put for $6.60; Buy the 135 Put for $3.07; Both options expire in 46 days.

Spread Entry Price: $6.60 Received – $3.07 Paid = $3.53 Received

Breakeven Price: $145 Short Put Strike Price – $3.53 Premium Received = $141.47

Maximum Profit Potential: $3.53 Premium Received x $100 = $353

Maximum Loss Potential: ($10 Spread Width – $3.53 Premium Received) x $100 = $647

As always, we’ll explain the profit and loss potential and directional bias with a visualization of the expiration payoff diagram:

Here’s an explanation of the key price levels on this expiration P/L graph:

Maximum Profit Potential

Stock Price(s): At or above the short put’s strike price of $145.

Why?: At any price equal to or above $145 at expiration, the 145 put and 135 put will both expire worthless. As a result, the net value of the 145/135 put spread will be $0.00, translating to a $3.53 gain per spread ($353 in actual profits per spread) since the spread was initially sold for $3.53.

Breakeven

Stock Price(s): $141.47 at expiration.

Why?: At $141.47, the short 145 put will be worth $3.53 at expiration, while the long 135 put will expire worthless. As a result, the net value of the 145/135 put spread will be $3.53, which is what was initially collected for the spread.

Maximum Loss Potential

Stock Price(s): At or below the long put’s strike price of $135.

Why?: At any price below $135 at expiration, the short 145 put will be worth $10 more than the long 135 put, which means the 145/135 put spread will be worth $10. With an initial sale price of $3.53, the loss per spread is $6.47 ($647 in actual losses per spread).

How Did the Trade Actually Perform?

You know how to determine the profitability of a short put spread at expiration, but how do these spreads perform when the stock price changes before expiration?

Let’s take a look at how this short NFLX put spread performed:

When the 145 / 135 short put spread was initially sold for $3.53, NFLX shares were trading for nearly $147.

Over the first couple weeks of the trade (between 46 to 28 days to expiration), NFLX shares sold off to about $140, and the short put spread value expanded to $5.00. As a result, the bull put spread trader had approximately $147 in losses per spread ($3.53 Put Spread Sale Price – $5.00 Current Spread Price) x $100 Option Contract Multiplier = -$147 .

Fortunately, NFLX shares surged from $140 all the way up to $160, and the stock price was trading at $157.02 at the time of the short put spread’s expiration date.

It’s clear to see that the increase in the stock price resulted in a swift decrease in the price of the 145 / 135 short put spread, as the put options became substantially out-of-the-money (OTM).

With NFLX shares at $157.02 at expiration, the short 145 put and long 135 put both expired worthless, which means the value of the 145 / 135 put spread was $0.00. With an initial sale price of $3.53, the profit on the trade is $353 per short put spread:

($3.53 Put Spread Sale Price – $0.00 Spread Expiration Value) x $100 Option Contract Multiplier = +$353 Total Profit Per Spread .

Bull Put Spread

A bullish vertical spread constructed with put options: one short put and one long put at a lower strike price in the same expiration.

The maximum profit potential occurs when the stock price is above the short put’s strike price at expiration, while the maximum loss potential occurs when the share price is below the long put’s strike price at expiration.

In short, traders who sell put spreads want the stock price to rise or trade sideways as time passes, as both will result in the spread losing value over time (generating profits for the put spread seller).

To continue learning about this strategy, check out our ultimate guide on the bull put spread.

Time Decay & Vertical Spread Performance

How does time decay play a role in the profitability of vertical spread strategies?

Well, let’s start with one law that applies to ALL call and put spreads:

To reach max profit, the extrinsic value of the options in the spread must reach $0.00.

Take a look at the following example:

Stock Price: $153.91

Spread: Long 150 / 152.5 Call Spread

Spread Price: $1.68

Maximum Spread Value: $2.50 (Width of Call Spread Strikes)

As we can see, the stock price is well above the short call’s strike price of $152.50, but the 150 / 152.5 call vertical spread is only worth $1.68.

If the stock price is still $153.91 at expiration, we know that the 150 / 152.5 call spread will be worth $2.50, so why is the spread only $1.68?

The answer is that both options have extrinsic value remaining:

Stock Price: $153.91

Option

Option Price

Intrinsic & Extrinsic*

*Intrinsic Value = Stock Price – Call Strike Price

*Extrinsic Value = Call Price – Intrinsic Value

If you look carefully, you’ll notice that the value of the spread is $2.50 when only including the intrinsic value of each option:

Long 150 Call: $3.91 of Intrinsic Value

Short 152.5 Call: $1.41 of Intrinsic Value

Long Call Spread Value (Intrinsic Only): $3.91 Long Call – $1.41 Short Call = $2.50

Pretty cool, right?

Now, how does time decay come into the equation?

Knowing this, here’s exactly what you want to happen when you trade each of the four vertical spreads:

Bull Call Spread: Stock price increases to a level equal to or greater than the short call’s strike price while each option’s extrinsic value decays away as time passes.

Bull Put Spread: Stock price increases/remains above the short put’s strike price as time passes (as the spread’s value will approach $0 as the extrinsic value of each put option melts away).

Bear Call Spread: Stock price decreases/remains below the short call’s strike price as time passes (as the spread’s value will approach $0 as the extrinsic value of each call option diminishes).

Bear Put Spread: Stock price falls to a level equal to or below the short put’s strike price while the extrinsic value of each put option decays as time passes.

Time Decay & Vertical Spreads

For a vertical spread to reach the maximum profit level, the extrinsic value of the options in the spread needs to reach $0, which happens with the passage of time and favorable movements in the stock price.

Implied Volatility & Vertical Spread Performance

As always, implied volatility (the prices of options) plays a huge role in every options trading strategy. So, how does implied volatility play a role in the profitability of the four strategies discussed in this guide?

Here’s how:

Implied volatility measures how much extrinsic value is being priced into a stock’s options:

More “Expensive” Options ➜ Higher Implied Volatility / More Extrinsic Value

Less “Expensive” Options ➜ Lower Implied Volatility / Less Extrinsic Value

In the last section, you learned that vertical spreads can only reach max profit if the extrinsic value in the spread reaches $0. With that said, you want implied volatility (option prices / extrinsic value) to decrease as the stock price is moving in favor of your spread.

Many sources will tell you that you want to buy vertical spreads when implied volatility is low, as you’ll benefit from an increase in implied volatility.

This is partially incorrect.

If implied volatility increases (with all else being equal), that’s an indication that traders have bid up the option prices and therefore they have more extrinsic value.

If implied volatility increases and the stock price is moving in your favor, you’ll have less profits than you would if implied volatility had decreased.

Consider the following example that estimates the P/L of a long 150/160 call spread in FB based on various implied volatility levels with FB rising to $160:

However, the one time you’ll benefit from an increase in implied volatility (more extrinsic value) when trading vertical spreads is when the stock price moves against you. For example, if you buy a call spread and the stock price falls, you’ll be better off if implied volatility increases while the stock is falling:

As we can see, the long call spread will have larger losses if FB implied volatility falls while the stock price is falling. However, if implied volatility remains the same or increases, the losses on the spread will be less severe.

Ok, we’ve covered some heavy content here, so let’s break down the key takeaways from this section as they apply to each vertical spread:

When buying call spreads or selling put spreads, you want the stock price to increase while implied volatility falls (as both will lead to less extrinsic value in the spreads). Fortunately, a implied volatility typically falls as the price of the shares rise.

When buying put spreads or selling call spreads, you want the stock price to decrease while implied volatility falls (as both will lead to less extrinsic value in the spreads). Unfortunately, implied volatility usually increases when the price of the shares fall. As a result, the profits from a stock price decrease may be offset by an increase in implied volatility.

Implied Volatility & Vertical Spreads

Implied volatility represents how much extrinsic value exists in a stock’s option prices.

Since vertical spreads require a decrease in extrinsic value to reach the maximum profit potential, you want implied volatility to decrease as the stock price is moving in favor of your spread.

However, if the stock price moves unfavorably, an increase in implied volatility (extrinsic value) will result in less severe losses.

The “Perfect Storm” for Vertical Spreads

Ok, so you know how time decay and implied volatility play a role in the performance of vertical spreads.

Let’s put all of the concepts together and describe the “perfect storm” for profitable spread trading (generally speaking):

Favorable Change in the Stock Price

Favorable Change in Implied Volatility

Bull Call Spread

Increase

Bull Put Spread

Bear Call Spread

Decrease

Bear Put Spread

In the above cases, the passage of time is a benefit, as extrinsic value decreases as expiration gets closer.

Choosing an Expiration Cycle

With so many different expiration cycles to choose from, which one should you trade?

Since vertical spreads can only achieve the maximum profit potential if the extrinsic value in the spread reaches $0, trading expiration cycles with less than 60 days to expiration is common.

Here’s how the expiration you trade will impact the performance of each vertical spread (assuming you’re comparing similar spreads in different expirations):

Favorable Stock Price Change: Short-term spread rises in value more than the same spread in a longer-term expiration cycle.

Unfavorable Stock Price Change: Short-term spread loses more value than the same spread in a longer-term expiration cycle.

In other words, when you’re correct about a stock’s price movements (e.g. you buy a call spread and the stock price increases), trading a shorter-term expiration cycle will result in quicker profits relative to the same spread in a longer-term expiration cycle.

On the other hand, when you’re wrong about a stock’s price movements (e.g. you sell a put spread and the share price falls), trading a shorter-term expiration cycle will result in larger losses relative to the same spread in a longer-term expiration cycle.

Let’s take a look at some real call spread trades in NFLX to demonstrate these concepts.

Expiration Comparison: NFLX Call Spreads

To demonstrate the differences between trading shorter-term and longer-term spreads, let’s look at some bull call spreads in NFLX from 2020.

Here are the trade details:

Entry Date: April 3rd, 2020

Stock Price at Entry: $146.92

Trade #1: Buy the May17 140/160 Call Spread for $8.74 (46 Days to Expiration)

​Trade #2: Buy the Jun17 140/160 Call Spread for $8.95 (74 Days to Expiration)

In this case, we’re comparing the same call spread (buy the 140 call, sell the 160 call) in two different expiration cycles.

Let’s see how each spread performs as NFLX fluctuates over the next 45 days:

As we can see, both spreads move with each other, as they are constructed with the same options.

However, when NFLX takes a dip to $140 in the first two weeks, we can see that the May17 call spread has lost more money than the longer-term, Jun17 call spread.

When NFLX shares traded up to $160, we can see that the 140/160 call spread in the May17 expiration cycle was up over $1,000 at the highest point. However, at that time, the 140/160 call spread in the Jun17 expiration cycle was up only $700.

Since the June call spread has more time until expiration relative to the May call spread, the June call spread has much more extrinsic value remaining. As a result, the June call spread requires more time to pass before the spread’s value can increase to a price similar to the shorter-term May call spread with very little extrinsic value.

The Time to Expiration “Sweet Spot”

So, should you choose a longer-term or shorter-term expiration cycle when trading vertical spreads?

Like many things in options trading, there isn’t one perfect answer. However, there is a “sweet spot” you can use to balance the amount of time you have for your directional bias to play out, as well as the decay of extrinsic value if you’re right about the stock’s direction.

What’s the sweet spot?

Anywhere between 30-60 days to expiration is quite common for most options strategies (including vertical spreads), as you get a great balance of time decay (which helps you if your directional outlook is correct), but also adequate time for your trade to recover if the stock moves against you initially.

Choosing an Expiration

When choosing an expiration cycle to trade, keep in mind that shorter-term expiration cycles will be more beneficial to trade if the stock price moves favorably during the time the trade is held. The reason is that shorter-term options have less extrinsic value, and therefore vertical spreads can achieve their maximum profit levels much quicker than longer-term spreads.

However, if the stock price moves unfavorably during the time the trade is held, trading a spread in a longer-term expiration cycle will be more beneficial, as longer-term options have more extrinsic value.

In general, trading options with 30-60 days to expiration is common.

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