How to Adjust the Vertical Option
A vertical option spread is an option trading strategy that offers both limited risk and limited maximum profit. A vertical spread involves the purchase of options contracts at a specific strike price and expiration date and the simultaneous sale of contracts at a different strike price with the same expiration date. A bull spread using call options will profit if the underlying security increases in value and a bear spread with put options profits if the underlying falls in value.
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Instructions
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The underlying stock moves in the anticipated direction
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In this example, a bull call spread has been established by buying Apple, symbol AAPL, $220 strike price calls for $1105 per contract and selling an equal number of $230 strike price contracts at $759 per contract for a net cost of $346 per contract. Maximum profit is achieved if AAPL, currently $209 per share is at $230 when the contracts reach expiration. Maximum profit is $654 (1,000 minus 346) times the number of contracts in each leg minus commission costs.
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As the value of AAPL increases above the $220 strike price of the purchased option, watch for time premium decay in the sold, $230 strike contracts. If the price between the contracts increases significantly, the sold contracts can be bought back at a lower price and the value of the purchased contracts can continue to rise as AAPL rises. This may happen if the stock trades between the $220 and $230 strike prices.
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As expiration nears, it is important to not have either side of the spread in the money at expiration. If AAPL is above both strike prices, the spreads should be closed out for the current credit of the spread. If AAPL is trading between $220 and $230, the purchased contracts should be sold to avoid automatic assignment at expiration. The sold, $230 options can be allowed to expire worthless.
The underlying stock moves in the wrong direction
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If, after establishing an option spread position, the underlying security has a price move in the wrong direction, the first step is to determine whether you believe the stock price will recover before the options expire. If you have just guessed wrong on the price direction, close out both sides of the vertical option spread for whatever credit is available.
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If the price is expected to recover, a price dip can be a good time to buy back the sold, higher strike price contracts. The sold contracts represent a future financial obligation if the stock price recovers. If the sold contracts become very cheap to the price originally received, buy them back.
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The vertical spread has now become a single leg of option contracts that will increase in value as the underlying stock increases above the strike price. Monitor the stock price and be ready to sell the option contracts when it appears the stock has reached its maximum value prior to the option expiration date.
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Tips & Warnings
Option contracts are for 100 shares of the underlying security. Quoted option prices must be multiplied by 100 for the cost. The AAPL $220 strike price option has a quoted price of $11.05 and a cost of $1,105.
Closing out one side of a vertical option spread should be based on a firm belief of the future stock price. If in doubt, close out the entire spread.
Vertical option spreads are popular because they have a low initial cost. The downside is the possibility of a 100 percent loss if both legs reach expiration out of the money.
The price spreads and commissions on option trading can have a significant impact on the expected return. Always account for these costs in your calculations.
