The short vertical strategy is a great way to increase the odds of having a winning trade especially during periods of high volatility which inflates the time value of an option. When time is expensive, a long vertical strategy can still make great returns on stocks expected to rise in value.
Short verticals are “short” because they are bearish or only used when the expectation is the underlying will drop in value. A short vertical on a call (also known as a bear call spread) credits your account while a long vertical on a put (also known as a bear put spread) debits your account.
Short verticals on puts have a higher profitability if the expected move happens, while short verticals on calls have a higher probability of some profit if the expected move doesn’t happen or isn’t as strong as expected.
A short vertical is a strategy that buys and sells two options of different strike prices but with the same expiration. The expiration chosen depends on how quickly the stock is expected to fall to the lowest strike price.
Here’s a quick recap of how a put option makes money:
XYZ underlying trades at $100
The $100 strike price option costs $5 with a 30 day expiration
If the $100 put is purchased, the price of that option ($5) is immediately debited from the account. The full $5 is what it costs for the 30 days of time. There is no intrinsic value. In other words, this option loses value every day for 30 days and will expire worthless unless the stock falls more than 5% in value.
A short vertical seeks to reduce this risk while increasing the odds of significant profits. A short vertical on a put (Bear Put Spread) increases the profitability of the trade if the stock makes the expected move, while a short vertical on a call (Bear Call Spread) increases the probability of a winning trade at the cost of reducing potential profits.
Short vertical on a put (also known as a Bear Put Spread)
Buying the $100 strike price put gives you the right to sell the underlying at $100. Selling the $95 strike price obligates you to buy the underlying at $95. This is a limited risk trade similar to a covered call. The only risk is the difference between the two strike prices ($5) which is further reduced by the amount of money made by selling the $95 stroke price put ($5 – $3 = $2 total risk).
For a straight put trade where the option is bought for $5, the underlying would have to decrease in value more than 5% to be profitable. This means, the underlying would have to fall more than $5 over the next 30 days to make money.
A short vertical strategy on puts (Bear Put Spread) reduces this risk by selling a lower strike price put with the same expiration to offset some of the expense of the higher strike price put purchased. In this example, we sell the $95 put which obligates us to buy the stock for $95. This obligation is covered by the $100 option we already purchased. Selling this put for $3, reduces the out-of-pocket expenses to just $2. This means the underlying now just has to decrease in value below $98 to be profitable.
A short vertical reduces the risk of the trade caused by expensive time, but also caps the upside. The maximum profit of $3 (-$5 original cost + $3 earned by selling the $95 put = -$2 + $5 increase in intrinsic value of the $100 option = $3 total profit) on this trade is only reached if the underlying decreases to $95 or lower.
At first this doesn’t seem that appealing…but think about it this way. A total of $2 was risked on the trade. If that $2 risk turns into a $3 gain, the net gain on the trade equals a 150% return even with a maximum cap to the earnings. This 150% is earned if the underlying only moves in the expected direction enough for the original option to break even (or down to $95 in this example). For the original $100 strike price to earn 150%, the underlying would have had to decrease in value to $85 within 30 days.
Short vertical on a call (also known as a Bear Call Spread)
Buying the $95 strike price call gives you the right to buy the underlying at $95. This is a limited risk trade very similar to a covered call. The only risk is the the amount of money paid for the $95 put ($3).
This trade is profitable if the underlying stays above $98. If the underlying rises to $105, this trade still only makes $2. At first this might not seem that appealing. But think about it this way:
A total of $3 was risked on the trade. If the underlying goes up, stays the same or even goes down a little bit, this trade will make money, whereas the Bear Put Spread only makes money if the underlying moves in the expected direction (down). If the stock stays the same or moves as expected, the full $2 credit (a 67% profit) is kept.
Short vertical strategies are employed when the expectations are the underlying will drop in value. They are especially useful as a strategy during periods of high volatility in the underlying such as around earnings announcements.
They can be done in a way that either debits your account or credits your account. The upside to doing a Bear Put Spread (which debits your account) is increased profitability. However the underlying must move in the expected direction to be profitable.
The upside to doing a Bear Call Spread (which credits your account) is increased probability of a profit, even if that profit isn’t as large as that from a Bear Put Spread play. In this scenario, the underlying can go up or stay the same for maximum profits and it will even make money as long as the underlying doesn’t go down too much (in this example less than 2%).