The vertical put spread, allows you to do the most important thing for options traders and that is to define risk. Know what you are risking when a trade is made. It is always amazing to me that so many people ask “what can I make?” As most professionals say “what can I lose?” I know I have mentioned this in previous articles, but it is so important that it always bears repeating. The trade itself consists of selling one put, a bullish position, reflecting your desire for the stock to go up, and then purchasing another lower strike put against it so that you define your maximum risk point on the spread. I usually like to have both of my strikes out of the money when I do this trade as it improves probabilities. As options are simply probabilities you can put on trades to improve the probabilities in your favor. So we do not just talk in esoteric terms here, let’s examine a real life example.
Our example for April 29, 2013, starts with the thesis that we want a long position in
As you see on our thinkorswim software we calculate probabilities based on the option pricing at that time, there is just over a 42% probability of that option being in the money on expiration day or as we are selling the option a 58% probability of being out of the money. We start with something that makes sense, having better than a 50/50 proposition, now we have solved for something we really like. There is one part of this that is not great, as it stands, we have large risk in that we could be put the stock at 410 and theoretically, although doubtful, the stock can go to 0. So our next step is to define our risk. An easy way to do so is to purchase the June 400 put for $8.00. This puts us in a situation in which we will receive $3.50 or $350.00, less transaction costs, for every time we do the trade as each contract is based on 100 shares. We have now defined our trade, you have a situation where if the stock price goes up we keep our money that is what we want as we started with a bullish bias, if it stays unchanged we keep our money as long as we are above $410. If it does go down, we do have a cushion of $12 before we are below our upper strike, but as we sold the spread for $3.50 our true breakeven is $406.50 (410-3.50).
Now anyone who looks at this has one question immediately and that is, why would I do a trade in which I am collecting $3.50 but risking $6.50. (Together that means the max value of the spread is $10. We get the 10 by taking the difference between the strike we sold ( 410) and the strike we purchase (400), even if the stock goes down the spread has a maximum value of $10).The reason we would do this is because the probability is so high that you will make some money.
Options probabilities are all based on making at least $0.01 before commissions. In our example, there is a 65% probability of this happening. We get that by taking the Total Risk of this trade, that is the maximum price the spread can go to in this case $10 and dividing the Real Risk by it, the Real Risk is the amount of $$$ that can come out of your pocket if the trade goes fully against you. Another way of looking at Real Risk is the Total Risk less the amount of premium received. In our case this would mean that we would take $6.50/10.00 and come up with 65% again before commissions. This is an old trick that we used as floor traders for years to have an idea what our probabilities were on spreads and is very useful as a retail trader. I like to use 50- 75% as a general guide on probabilities on these types of trades as I like better than 50% on most trades and when you get above 75% you do not receive much premium.
The short vertical put spread allows you to express a long opinion on a stock in a way that options traders love. The reason they love it is you can define your viewpoint, you can define your maximum risk, you can define your probability of success and you can define by the month you choose the maximum length of the trade. In other words you take away as many unknowns as possible. Do not forget you can use this with calls also and so if you would like to express a directional bias, the short vertical, be it through calls or puts can be an intelligent risk defined way to do so.
Options involve risk and are not suitable for all investors. Before trading options, please read Characteristics and Risks of Standardized Options. Spreads and other multiple-leg option strategies can entail substantial transaction costs, including multiple commissions, which may impact any potential return. Transaction costs (commissions and other fees) are important factors and should be considered when evaluating any options trade.
Commentary and examples provided for educational purposes only. Should not be considered a recommendation for any specific security or strategy. Probability analysis results are theoretical in nature, not guaranteed, and do not reflect any degree of certainty of an event occurring. Supporting documentation for any claims, comparison, statistics, or other technical data will be supplied upon request.
