The Long Vertical Cure: Debit Spreads

By Kevin Lund

Imagine the following scenario: The market has been volatile, but you're still bullish for the next several months and you'd like to trade a diversified group of stocks. You've picked four good candidates from different sectors, all priced around $50, and you want to buy 100 shares of each. Does this seem to be a sound strategy so far? Sure. But suppose you only have $5,000? What are your options now?

A. Take out a cash advance on your credit card to fund the purchase.

B. Buy as much stock as you can on margin and borrow the rest from your friends and relatives.

C. Create a portfolio of long vertical spreads.

Of course, if you picked "A" or "B," then you may need to move out of the house sooner than you think and leave your family and credit cards out of this. If you picked "C," but aren't sure why, read on.

Long vertical spreads (also known as vertical debit spreads, or simply debit spreads) are a relatively conservative option strategy that profits from a directional move in a stock, using much smaller amounts of capital than an outright stock purchase. While there are a number of other options strategies you could use to speculate on a stock's direction, at- or out-of-the-money long verticals can be particularly useful under certain conditions.

THE MECHANICS

Long verticals are made up of a long (bought) option and a short (sold) option, both either calls or puts, and both expiring in the same month. With long verticals, you incur a debit because you're buying the strike that's closer to the money and selling a cheaper strike, further out of the money. Unlike other option spreads, long verticals are pretty straightforward. If you're bullish, you'd buy a call vertical spread, and if you're bearish, you'd buy a put vertical.

Long verticals are ideal alternatives to buying straight calls and puts when the conditions aren't quite right to do so. The most obvious advantage of buying the call vertical over a straight call position is simply that it's cheaper. But it's a trade-off. You might be paying less for the spread for similar leverage as a straight call, but unlike with the latter, at some point, your profits get capped, depending on where you sell your short strike. (For more on this, see the "Schaeffer's Take" sidebar, below).

The long vertical profits because as the stock moves in favor of the trade, the long strike's option makes money faster than the losses incurred at the short strike due to its "moneyness" or position relative to the stock. Your maximum profit achievable is at expiration, when there is no more time value in the options, but of course, there's no rule that says you need to wait until expiration to cash in and close the trade if you find yourself with a profit before then.

BUILDING THE TRADE

Let's look at an example using the stock XYZ. Suppose you're bullish on XYZ at $70. You might buy the 70 strike call for $5 outright, or you could reduce the cost even further by turning it into a long vertical. By selling the 75 strike call for $3 to form the 70/75 long call vertical, you've reduced your debit in the trade from $5 to $2, which is also your maximum risk (see Figure 1). Now, unlike the unlimited potential of the call, the most you can close the spread for is $5 (at expiration), so your maximum profit is $3 ($5 – $2). To calculate your breakeven, you simply add your net debit of $2 to the long strike, or $72 on our XYZ trade. Note that if you were bearish on XYZ and bought the 70/65 put vertical for the same $2 debit, your breakeven is $68 (see Figure 2).

Perhaps the most common questions asked about setting up a long vertical trade are: What should the reward to risk be? And, where do you place your option strikes? It's a bit of a balance and ultimately depends on a couple of factors. When it comes to reward to risk ratios for long verticals in low-volatility environments, you should shoot for 3 to 1 or better (in other words, spend $1 to make $3). In higher volatility environments, anything above 1 to 1 is a good rule of thumb.

Among other factors, good reward to risk ratios can have a lot to do with where you set your strikes for the spread. Typically, if you want to be more aggressive and maximize your reward to risk, you would place your long leg of the spread out-of-the-money (OTM) by at least one strike. Any more than two strikes and you'll have a very low-delta (low-probability) trade that will not likely profit much, even if the stock moves in your favor. To create a higher-probability, lower reward-to-risk trade, you'd simply set the long strike at-the-money (ATM). The rewards won't be as high as the OTM spread, but you have a better chance of making a profit, so again, it's a trade-off. Ultimately, the final decision will likely have to do with how strong your conviction is on the direction of the underlying prior to expiration of the spread.

On a side note, at some point you may end up asking: Why not buy in-the-money (ITM) verticals? While the answer is a bit more complex than this article has room to answer, part of the reason is that it's a liquidity issue. Options that are ITM are typically less liquid simply because there is less demand for them. When there is less demand, "slippage" increases, which is the spread between the bid and ask prices, and you'll wind up paying too much for that ITM spread. However, that said, the ITM long vertical is the synthetic equivalent to its OTM short vertical counterpart (that is, buying the ITM call spread is the same as selling the OTM put spread using the same strikes), the properties of which can have some distinct advantages under certain conditions. It's worth exploring. (For more on short verticals, see "Going Vertical," SENTIMENT, Spring 2009).

OTHER BENNIES

The beauty of long verticals is that they are very accommodating to a number of market conditions and can act as an effective surrogate for other strategies. To name a few:

Got Time? Long verticals are a perfect strategy for moderately bullish or bearish market conditions, particularly when volatility is high or the timeliness of the next breakout is uncertain. By design, debit spreads enjoy a built-in hedge against time passing and volatility risk. If time starts to decay your options, or volatility plummets during the life of the trade, both options lose value. However, while you lose in your long option, you gain some back in the short—mitigating some of that time and volatility risk (for more on this, see the "Schaeffer's Take" sidebar, starting on page 19).

Easy to Manage. Using long verticals in lieu of a stop loss on a call can streamline your trade management. How? Suppose a call is $5, and you have a $2.50 stop. If you've been trading options long enough, you probably know that the move from $5 to $2.50 is hardly linear and smooth, often gapping from one price to another each trading day. When the market is showing higher levels of volatility, and taking your options along with it, you may find yourself getting whipsawed out of trades unintentionally, or worse, getting filled at a price far below the stop you set in the event that it gaps through it.

So, instead of fussing over stops in a volatile market, next time you buy that $5 call, go ahead and short the strike above it to create the long vertical, with the aim of reducing your overall debit (risk) to $2.50—the same $2.50 you wanted to set your stop for on the straight call. Now (dare I say) you won't need to set a stop at all, and can let the market take your position where it wants to. If the stock falls off a cliff, you can never lose more than the $2.50 you considered an acceptable loss to begin with.

Small Retirement Accounts . Finally, while regulatory reforms are now in place to curb bad behavior from our beloved financial institutions, the regulatory walls surrounding the use of options in personal IRAs have been torn down for some time. Though you still can't trade on margin in an IRA, many smart brokers now allow you to trade options and option spreads in your retirement account. If the idea of trading shorter-term options in your IRA makes you a little uneasy, consider using longer-term options that can expire as far out as three years, such as LEAPS, to build a long-term, long vertical portfolio. Check that time frame against the average time you hold onto a stock position, and this strategy might just make sense. And since Uncle Sam won't allow you to contribute more than $5,000 this year ($6,000 if you're over 50), this is one way to maximize your contribution without bending any rules. (Suddenly that investment in GOOG doesn't look so far off, huh?)

Whether you're a long-term investor or a short-term trader, options offer so many different ways to achieve your investment objectives, it's a wonder that they're still considered an "alternative" investment strategy at all. When you consider that buying call vertical spreads can provide as much or more leverage as a bullish stock position, while cutting your dollars at risk by as much as 90% (or more), they certainly deserve a second look, even by the most conservative skeptic. Despite the argument that such things as time decay and volatility exposure make for a different risk profile than stocks, long spreads can be so effective in mitigating such risks that they can actually turn the standard risk assumption between stocks and options on its head. It's enough to make even the most conservative stock portfolio look like a Vegas casino. Oh, but if you're still actually holding stocks, you probably already knew that, didn't you?

Schaeffer's Take: When trading vertical debit spreads, we at Schaeffer's prefer setups in which we have high conviction on the direction of the underlying stock over the next several weeks or months. Since we have a directional bias, this might ordinarily suggest that a simple call or put purchase is the appropriate strategy. However, there may be reasons to mitigate the time decay risk of the straight option purchase.

For example, consider situations where the option premiums on the underlying might be considered "rich." This "richness" can be defined by higher-volatility expectations (as reflected in the implied volatility of the options) than historical volatility, or by implied volatility being on the high end of its annual range, or by implied volatility being high on an absolute basis because the underlying is extremely volatile. By purchasing a vertical debit spread in these situations, we are partially mitigating the extra time decay risk embedded in the long option portion of the spread by selling a lower delta option against it. Plus, we're lowering the net debit in the transaction, which is important because a smaller move is needed by expiration to realize a profit compared to a straight put or call purchase.

In addition, there are instances where we might be confident about the stock's direction, but uncertain as to how quickly the move will occur. By selling a lower delta option, we can dampen the effects of time decay on the position should the underlying chop around in a range before making the move that we expect. By initiating a vertical debit spread in a breakout situation, you can profit when the follow-through is immediate or when there is an initial period of congestion followed by a resumption of the trend.

So the main advantages of vertical debit spreads are: (1) they mitigate time decay risk and the extra challenge of high implied volatility for the option buyer; and (2) they create a more favorable breakeven point.

To be fair, there are some disadvantages to this strategy. First, the maximum gain is usually not fully realized until expiration, as the sold option will have more time premium embedded in the premium than the purchased option. Therefore, in situations in which the underlying makes a fast and aggressive move in the anticipated direction, you must wait until closer to expiration to fully realize your profit potential on a long vertical spread. In playing this waiting game, you run the risk of the underlying moving against you. Second, your maximum gain is capped by the strike of the option you sell, which means you cannot fully participate in explosive moves by the underlying in your favor.

One final, but important, point: Pay attention to the bid/ask spreads (the difference between the bid and ask prices). Since you are buying at the ask and selling at the bid, the negative cumulative effect of wide bid and offer prices when opening and closing vertical spreads can seriously undermine your ability to generate profits.

--Todd Salamone
Schaeffer's Investment Research

"the problem with $1 strikes on every chain is the number of overall strikes gets out of hand on thinly traded stocks. whenever there is a decent amount of trading they add the $1 strikes, except the really high dollar stocks. "
Respond

"The trouble is with options priced with $5 increments, without a lot of volume, you're in a position where the market maker is deciding the price. As there is often over $1 ($100) between the bid ask on these trades. When I spoke with the CBOE they suggested adding the bid to the ask and dividing by two to find the approximate true value of the spread. Then move your price around until filled by the market maker. That will cost you! Every time you cancel/change an option order you're likely charge a $2.00 fee. My suggestion. $1 strikes on every option chain. Let's petition the SEC. Who's with me? "
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