Keep Your Risks Low With This Strategy

Option trading has become increasingly popular lately. They offer more flexibility and require less capital commitment than vanilla stock trading. And because they offer leverage, for traders looking for action and quick gains, options also offer an excitement factor.

You can always just straightforwardly buy or short an option. However, many experienced traders like to use a combination of different options to better manage their risk.

A common strategy is a spread. Today, I will discuss the horizontal and the vertical spread.

A horizontal (aka calendar) spread is when you simultaneously buy and write either a call or a put with the same strike price but different expiration date on the same underlying stock. A vertical spread differs from a horizontal spread in that the two legs of the trade have the same expiration date but different strike prices.

Consider the following horizontal spread.

How It Works

Using real-time market data as of this writing, you could short one October 21, 2022 $12 call contract for Snap Inc. (NSDQ: SNAP) for $1.06. Simultaneously, you can buy the November 18, 2022 $12 call for $1.44.

The key point to note is that in this example you short the shorter-dated call and long the longer-dated call.

Ignoring commission cost, your net proceeds from the two trades is negative $38 ($106 – $144). This $38 debit is the maximum you can lose. It occurs when both options expire worthless or when both options are exercised.

The ideal scenario for you would be if SNAP stays under $12 through the October short call expiration, so that the October call option expires worthless (which would be good for you), but then the stock rallies right after that so that the November call goes in the money. If the November call ends up worth than $0.38 at expiration, you will end up with a profit on the spread.

Protected From Large Loss

You might be worried what if SNAP rallies to above $12 before the October expiration? Wouldn’t it be exercised and you would need to deliver the shares?

That’s where the long leg of the trade serves as a hedge. You can exercise the November option and offset your position.

You do such a spread when you are bullish on a stock but want to reduce the net cost of buying a call. You also limit your maximum loss to a set amount no matter what happens to the price of SNAP. Note that you can choose whichever expiration dates you want, the two contracts don’t need to be one month apart as in the example.

Let’s say instead of being bullish on SNAP, you are bearish. In this scenario, you can write a shorter dated put and long a longer-dated put. It would work the same way as in the above example. The difference is you are trading puts instead of calls.

Alternatively, if you wanted to do such a bear spread with calls, you would buy the shorter-dated call and write a longer-dated call, but this opens you up to higher potential loss.

What About a Vertical Spread

Sticking with SNAP as example, to do a bull call vertical spread, you could buy the November 19, 2002 $11 call for $1.85 and sell the November $13 call for $1.05 for a debit of $80. Note that you are buying the call with the lower strike price and selling the call with the higher strike price.

Again, you limit your maximum loss to $80. This happens when SNAP is below $11, in which case both call contracts expire worthless, or when the stock is above $13, in which case both contracts are exercised and offset each other.

When SNAP is between $11 and $13 is where profit and loss can change. Ideally, you want SNAP to be as close as possible to $13 but below$13. Let’s say SNAP ended at $12.80, then you have $1.80 profit on your long call and the short call expires worthless. Your gain would be $100 ($180 – $80). If SNAP was at $11.50, then you will have a $50 profit on the long call option but it’s not enough to offset the $80 debit, so your loss would be $30.

In the vertical spread, you again limit your maximum loss, but you also cap your maximum gain. It goes without saying that spreads aren’t the right fit for everyone. Option traders who want to maximize risk and swing for the fences with each trade won’t want to do a spread. However, over the long run avoiding big losses are just as important as getting big wins. Only you can determine what’s best for you given your individual situation.

Editor’s Note: Want to reduce risks, without sacrificing performance? Turn to our colleague Jim Fink, chief investment strategist of Velocity Trader. A renowned options trader, Jim has developed a proprietary investing method that consistently beats Wall Street in markets that are going up, down or sideways.

In this new Investing Daily video, Jim Fink reveals how he hit 626 winners in 647 closed trades. Click here to watch.