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intro to spreads
Short Put Vertical
Analyzing the risk profile of a short put vertical
Variation In Strike Price
Let's take a look at how selection affects this strategy. Studying these concepts can help you understand how to customize your vertical to accommodate your profit goals, capital limitations, and risk tolerance.
Standard Setup
The basic idea of a short put vertical is to sell an OTM put (usually between -25Δ and -40Δ), and buy a cheap farther OTM put to limit your risk. In this case, we sold a -40Δ put against a long -10Δ put for a net $1.00 credit:
Our maximum profit is the credit we collected ($1.00), and our max potential loss is the width of the strikes less the credit:
Max Loss = $3 - $1 = $2
Looking at the chart, notice how the current share price (the blue dotted line) has room in the green zone both above and below. It indicates that this strategy can be profitable if the share price rises to any level, stays exactly the same, or declines by up to $2.00. As you can see, our break even is around the 30Δ. That means there's only a 30% chance our position expires in the red zone. Another way to say that is, our position has a 70% chance of expiring in the green zone. This high POP level is part of what makes short verticals so powerful.
Farther OTM
In this scenario, we've moved our strikes farther OTM. As you can see by the delta of our break even, our POP has gone up significantly, but so has our max potential loss. Our maximum profit potential has also drastically declined. Trading is a never-ending balancing act of risk, reward, and probability of profit – verticals are great for showing this balance plainly.
Narrower Strikes
Whenever we pick strikes that are extremely close to one another, we create friction which slows the rate of our P/L. The two legs end up competing with each other, cancelling out any profits or loss until either the share price moves to an extreme in either direction, or the position comes close to expiring. In this scenario, both our max profit and max loss are very low, but our probability of experiencing max loss is much higher than the previous examples.
Wider Strikes
In contrast to narrow strikes, wide strikes will allow our P/L to fluctuate quite a bit. This can allow us to make faster profits, but also exposes us to larger loss potential and a more volatile position. As you gain experience, you'll learn more about your personal risk tolerance and tailor your spreads to volatility levels you are comfortable with. Also take note that in this example, max profit and max loss are high, but the probability of expiring at either are lower – we have a 50% probability of max profit, and a 5% probability of max loss. We also have nearly 65% odds of breaking even.
Straddling the Share Price
In this scenario, we give up our favorable odds of max profit in exchange for a higher profit potential. By selling an ITM put, we incorporate into our trade. This intrinsic value can make us good money, but we have to be in order to claim it. Still, in this case we are selling more extrinsic value than we are paying, leaving us with slightly favorable odds of breaking even. Our odds of max loss are fairly high (about 20%), but our max risk is also proportionally lower.
ITM Spread
One last example we should look at is an ITM spread. In this scenario, we are risking a smaller amount to make a larger amount. This causes our odds of profit to be very low and our odds of max loss to be extremely high (about 60%). We are highly likely lose on a trade like this, but if we get lucky, we have the potential to make a large profit. I only show this to you to help you achieve a deeper understanding of how these spreads work.
I would personally never do a trade like this last example because of the poor odds of success. There's only a 10% chance of hitting max profit, and because we are paying more extrinsic value than we are selling, this setup would create a negative That means its profitability is hindered by the passage of time. In order to make money, it needs a large move in the correct direction almost immediately... better hope luck is on your side with this one!