Which vertical option spread should you use?

spread strategy Strike price Debit card credit card Maximum.get Maximum.loss break even
Bull call Buy phone C1
Write call C2
C2> C1 strike price debit (C2 − C1) − Premium paid Premiums paid C1 + Advanced
Bear call Write call C1
Buy phone C2
C2> C1 strike price CEDIT Premium received (C2 − C1) − Premium received C1 + Advanced
Bullish put Write P1
Buy put option P2
P1> P2 strike price CEDIT Premium received (P1 − P2) − Premium received P1-Premium
Put option Buy put option P1
Write P2
P1> P2 strike price debit (P1 − P2) − premiums paid Premiums paid P1-Premium

Credit and debit spreads

There are two main reasons for using vertical spreads:

  1. For debit spreads, reduce the amount of premiums payable.
  2. For credit spreads, reduce the risk of option positions.

Let us evaluate the first point. When the overall market volatility rises or the implied volatility of a particular stock is high, option premiums can be very expensive. Although the vertical spread limits the maximum benefit of an option position, it also greatly reduces the cost of the position compared to the profit potential of an individual bullish or bearish one.

Therefore, this spread can be easily used during periods of rising volatility, because the volatility of one side of the spread will offset the volatility of the other side.

As far as credit spreads are concerned, they can greatly reduce the risk of writing options, because the option seller takes a considerable amount of risk to earn a relatively small amount of option premium. A catastrophic trade can obliterate the positive results of many successful options trades. In fact, option authors are sometimes referred to as derogatory people as people who stoop to collect pennies on railroad tracks. They are happy to do this-until a train comes and runs over them.

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Writing naked or uncovered call options is one of the riskiest option strategies, because if the transaction goes wrong, the theoretical potential loss is unlimited. The risk of selling put options is relatively small, but an active trader who sells put options on a large number of stocks will be trapped by a large number of expensive stocks in a sudden market crash. Credit spreads mitigate this risk, even though the cost of this risk mitigation is lower premiums.

Which vertical spread to use

Consider using bull market spreads When the call option is expensive due to increased volatility, and you expect a moderate increase rather than a huge gain. This situation usually occurs in the later stages of a bull market, when the stock market is nearing its peak and it is difficult to realize returns. Bull market spreads may also be effective for stocks that have great long-term potential but have increased volatility due to the recent plunge.

When volatility is high and a mild downward trend is expected, consider using a bear market call option spread. This situation usually occurs in the final stage of a bear market or pullback, when the stock market is close to a trough but volatility is still high because pessimism prevails.

Consider using bullish put option spreads to earn premium income in a laterally rising market, or to buy stocks at a low price when the market fluctuates.It is possible to buy stocks at a low price because of the written put option possible The exercise buys the stock at the strike price, but because the credit is received, this reduces the cost of buying the stock (compared to the direct purchase of the stock at the strike price).

This strategy is particularly suitable for accumulating high-quality stocks at low prices when there are sudden fluctuations but the underlying trend is still upward. The bull market bearish spread is similar to “buy on dips”, with the additional benefit of obtaining premium income from bargaining.

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When a stock or index is expected to experience a moderate to significant decline and increase in volatility, please consider using a bear market put option spread. During periods of low volatility, you can also consider using bear market put option spreads to reduce the amount of premium paid in US dollars, such as hedging long positions after a strong bull market.

Factors to consider

The following factors may help to propose an appropriate option/spread strategy based on the current situation and your prospects.

  • Bullish or bearish: Are you positive or negative about the market? If you are very bullish, then you’d better consider individual call options (rather than spreads). However, if you expect a moderate increase, you can consider the bullish call option spread or the bullish put option spread. Similarly, if you are moderately bearish or want to reduce the cost of hedging a long position, then a bear market call option spread or a bear market put option spread may be the answer.
  • Volatility perspective: Do you expect volatility to rise or fall? Rising volatility may benefit option buyers, which are beneficial to borrower spread strategies. Declining volatility increases the odds of option sellers, which is conducive to credit spread strategies.
  • Risk and reward: If you prefer limited risks but may get greater returns, this is more like an option buyer’s mentality. If you seek limited returns for potentially greater risks, this is more in line with the mentality of option authors.

Based on the above, if you are moderately bearish, believe that volatility is rising, and are more willing to limit risk, then the best strategy is to bearish spreads. Conversely, if you are moderately bullish, believe that volatility is falling, and are satisfied with the risk-reward return of selling options, then you should choose a bull market put spread.

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Which strike price to choose

The above table summarizes whether the purchased option is higher or lower than the exercise price of the sold option. Which strike price to use depends on the prospect of the trader.

For example, for a bull market call spread, if the stock price may remain around $55 before the option expires, you can buy a call option with a strike price close to 50 and sell a call option with a strike price of 55. If the stock is unlikely to fluctuate significantly, then selling call options with 60 strikes is not so meaningful because the premium received will be lower. Buying 52 or 53 exercise call options is cheaper than buying 50 exercise call options, but lower exercise has less downside protection.

There is always a trade-off. Before trading in spreads, please consider what to give up or gain by choosing a different execution price. Consider the probability of getting the greatest gain or suffering the greatest loss. Although it is possible to create a transaction with a high theoretical return, if the probability of obtaining that return is small, and if the probability of loss is high, then a more balanced approach should be considered.

Bottom line

Knowing which option spread strategy to use under different market conditions can significantly increase your chances of success in options trading. Look at the current market conditions and consider your own analysis. Determine which vertical spread is most suitable for this situation (if any), and then consider which strike price to use before triggering the trade.

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