Have you ever wanted to bet or be in the market but with limited risk? Have you ever wanted to trade but do not have enough money to do it? If you said yes to any of the above questions, you should probably be aware of the Vertical Spread.
Vertical spreads are a very effective way to have exposure to moderate directional movements on the underlying asset. They can be tailored to state the trader’s view on the outlook. But what are vertical spreads?
A vertical spread is an option strategy in which you simultaneously buy and sell options of the same type and expiry but at different strike prices.
The best time for this kind of strategy is to trade near a support or a resistant level coupled with primer indicators of overbought/oversold conditions such as momentum indicators.
Furthermore, suppose there is any indication of a reversal pattern. In that case, if you have the idea that a bounceback or a pulldown is about to happen, you should probably explore different indicators and open a vertical spread, for instance, the ideal conditions for Bull Vertical Spread: Oversold condition and Implied Volatility high.
Talking about the strike price, near-to-the-money strikes have better Risk/Reward (RR) but low profitability. On the other hand, far-out-of-the-money has low RR but high profitability. The best conditions are:
You can expect to have 1/3 of the spread width as income with a RR of 2 with a 60%-70% probability of delivering profit.
Enter into a position is just one part of the equation. The other one is the exit rule. As a general rule, the take profit should be around 75% of the premium received. However, there are more specific rules to follow to maximize profit expectancy in the long term:
- 50% or more if there is more than half of the time left to expiration (take profit).
- If credit is > 1/5 of the spread, you should cut losses at 75%-100% of the premium received.
- If credit is <1/5 of the spread, you should cut losses at 100%-200% of the premium received.
Vertical spreads are ideal setups for newbies in options trading as long as they allow them to have exposure to directional bets with limited both profit and loss. There are a few considerations to have for maximizing the likelihood of being profitable in the long run.
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