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intro to spreads
Introducing Defined-Risk Strategies
Learning to establish limits using vertical spreads
Introducing the Vertical
Let's take a look at an example of how we can define risk. We'll start with something we've seen before... a 50Δ :
As you can see in the red zone, losses can add up quickly as the share price falls – $100... $200... $300... etc. If the price keeps crashing, the emotional stress can cause us to act out of panic, and make illogical decisions. With defined risk strategies, we can avoid that stress entirely by capping the risk to an amount we are comfortable losing – a failsafe if things go horribly wrong. In the scenario above, all we have to do is buy another put to cap our risk.
Visualizing the Risk
As an example, let's say we bought the 10Δ put for $0.15. This would cap our losses at the 10Δ strike. The resulting risk profile would look like this:
In this scenario, we have created a strategy called a "Short Put Vertical." We have simultaneously sold the 50Δ put and purchased the 10Δ put for a total net credit of $1.35. This credit is our maximum potential profit.
Max Profit = $1.50XX - $0.15XX = $1.35
In order to make money on this trade, our goal is to buy it back for less than we sold it for. Remember that as long as the puts stay (meaning they remain below the share price), their values will decay down to $0 by expiration. If the share price falls below our strikes, the puts will increase in value and our position will begin to lose. The worst case scenario would be if the share price fell completely below our long strike. If this happened, the most we'd have to pay to close the spread is the width of our strikes: $4. Knowing this, we can calculate our maximum potential loss. All we have to do is subtract our original credit from the width of the strikes:
Max Loss = $4 - $1.35 = $2.65
There are four types of verticals and all of them look very similar to this example – capped profit potential, and capped loss potential. Verticals are the most basic of defined risk strategies. By defining risk like this, we can now create spreads in any product that offers options. It doesn't matter if the product is $20 or $2000 per share – defined risk strategies like the short put vertical allow us to participate in any sector, company, and commodity without risking our entire accounts. In order to master this powerful strategy however, we'll need to take a closer look at how the two options work hand-in-hand. I'll discuss that on the next page.