Risk Profile: Defined
Number of Legs: 2
Level of Complexity: ⅖
Buying Power Needed: 3/5
Net Short or Long Premium?:Both, depending on which type of vertical spread.
However, we prefer to short premium with the vertical call spread
The Vertical Spread is a simple options trading strategy with a defined risk profile and a directional bias. You’ll also hear it referred to as a “bull call spread,” “bear call spread,” “bull put spread,” and “bear put spread.” A vertical spread consists of two contracts in the same expiration with different strike prices: one long and one short.
When to Use a Vertical Spread
The vertical spread will be used as one tool within your arsenal of trading strategies, with utility only in certain market environments.
The vertical spread works for when you have a directional bias in an instrument, but the implied volatility is high and options are expensive. Instead of buying a call or put outright, you essentially hedge out a lot of your exposure to premium by shorting an option along with your option purchase. While this does have the effect of limiting your profit potential, it also lowers your risk considerably, which makes this strategy ideal for those who want less variance in their returns.
The difference between the equity curves of trading a vertical spread and simply going long a put or call might look like this, with the red curve being solely a put or call, and the blue curve being the vertical spread.
Let’s go into the options market and find some ideal setups to trade a vertical spread:
We’re going to look at vertical spread trade setups in the Tesla stock. With implied volatility being quite high in Tesla right now, there’s a great deal of premium built into these options, which is a great opportunity to get short premium. We’ll take stock of a few ways to play Tesla using vertical spreads, depending on your directional bias.
Let’s assume you’re bearish on Tesla. A few catalysts supporting your thesis would be:
- Q3 revenue in China down $154M YoY, Chinese competitor NIO is gaining momentum in the EV market
- Tax breaks in US and Netherlands expiring in two months
- Rising interest rates make a potential capital raise even more difficult for an unprofitable company in a capital intensive industry.
- Elon Musk’s erratic behavior makes one question his decision making
- Production hell
It’s important to note that I’m not trying to convince you of anything, to be long or short Tesla, but actually setting up a reason to trade is important. I can click around an options table all day and show you attractive looking spread trades, but that only helps if you’re a completely systematic trader with no directional bias or discretionary views. Developing a skeptical, discretionary view of the market might save you from making bad trades that look attractive on paper.
I liken this to the idea of value traps in the value investing world. You can mess around with a stock screener and find all types of juicy value stocks. More cash per share then the share price, negative enterprise value, low ratios, etc., but often times, there’s a reason those stocks are so cheap, like an impending lawsuit is forcing them to hoard cash, or unambitious management.
From a technical analysis standpoint, there’s also some reasons to be bearish on Tesla. If you look at the weekly chart, Tesla has been in a trading range for the better part of two years now, going through regular boom and bust cycles. It seems like every time the price reaches the top of it’s range, some sort of scandal with the company comes out, whether it’s questionable behavior from Musk, or an expose in a major publication. On the contrary, it seems as if whenever it gets to the bottom of it’s range, the company has some great news, or Musk announces a new product idea. After you read our section on iron condors, you’ll see why TSLA could also be a good iron condor trade too.
Combining those bearish catalysts with TSLA’s tendency to mean revert, let’s assume we want to express a bearish view on Tesla. We’ll look at simply buying a put outright, compared to some vertical spreads.
If we purchase a Tesla in-the-money put expiring January 18th, 2019, it will cost us about $31.00 in premium, or about 9% of Tesla’s $341 share price. That means that we only profit when the stock is below $311, and that the January 18 expiration is pricing in a 51% annualized move in Tesla. Even given Tesla’s volatility, that seems a bit rich.
Further, if the price-channel catalyst is at all valuable to you, $311, your breakeven price, is about halfway down the price channel. Not only does Tesla need to mean revert, but it needs to go considerably below $311 in 78 days for you to profit. This is what makes outright options trading so difficult, you either need to be excellent at not only directional trading, but also market timing.
The red line is your break-even point in the above naked option example.
This is where vertical spreads come in, we can limit our premium exposure while still expressing our directional view. The downside, of course, is that our profit potential is capped. There’s no free lunch.
We’re going to look at short call verticals (bear call spread) and long put verticals (bear put spread), the two vertical spreads that are directionally bearish.
Here’s the options table for the expiration we’re going to focus on. With the volatility in price, sentiment, and outlook in Tesla, choosing a further out expiration seems like a good idea as it gives us time to be right. There’s a considerable amount of volume being done in about half of these strikes as well, which will make spreads tighter.
The first spread we’re going to look at is a short call vertical spread, also known as a bear call spread. The anatomy of this spread is as follows:
- 1 Short Call
- 1 Long Call, above the short call’s strike price.
Generally, people short an ATM (at-the-money) call and buy an OTM call, however, as long as the call’s strike is above the short call’s strike, the strategy is still considered a bear call spread.
All contracts are to be in the same instrument and expiration. This is a net credit spread, meaning we’re net sellers of options and we’re receiving a premium, rather than paying one. Further, time decay plays in our favor, rather than against us in this strategy.
Here is the payoff diagram for this spread:
We’re going to show you an example of a 1 standard deviation wide bear call spread in Tesla’s January 18th expiration options, with our short call being at the money, and our long call being one standard deviation away from that.
In selling the $340 call, we will receive $33 in credit, and in purchasing the $450 call, we are paying $2.84 in premium, giving us a net credit of $30.16. This makes our break-even price $370.21 (short strike + net credit), meaning as long as the price of Tesla’s stock stays below $370.21, we are making money on this trade.
Going back to our price channel, our break-even price of $370.21 (red line) is much more attractive now.
Maximum Gain & Loss
Most options trading platforms will calculate your break-even, max profit, and max loss levels for you. That, however, doesn’t mean you shouldn’t understand how to calculate these levels. If you can’t explain why one of your risk levels is where it is, then you don’t really understand the trade you’re putting on.
Values expressed in percentages of maximum loss
Credit Received x 100
$31.28 x 100 = $3,128
Here is a payoff matrix for our TSLA bear call spread. Pay special attention to the values at expiration. As you can see, if TSLA’s stock is below $345, our short call strike, at expiration, we reach the max profit of $3,128. The profit is the same whether the stock settles at $318 or $344, this is because both options expire worthless, so the max we can gain is the premium on both of the options.
Remember, when we short options, we want them to expire worthless, allowing us to keep all the premium. If TSLA settled below $345 and we were short the $TSLA $345 call naked, then we would receive $34.25 (the premium) of profit at expiration. However, because we also bought the $450 call for $2.97 and it expired worthless, we receive our net credit of $31.28 x 100 = $3,128 at expiration
(Width Between Call Strikes – Net Credit Received) x 100
($105.00 – $31.28) x 100 = $7,372
Our best case scenario is that both calls expire worthless, and our worst case scenario is if both calls expire in the money, meaning TSLA would have to be trading above $450 at expiration.
Again, a bear call spread is a short-premium strategy, so we lose money when options expire in-the-money. So, why do we stop losing money once the price goes above $450? This is where our $450 call comes in. When price is above $450, our long call is in-the-money and offsets losses from our short call. Our loss from our short call is theoretically unlimited and only capped by our long call.