Short verticals are contracted through buying and selling either calls or puts at different strikes, but within the same expiration. Thus, they’re setup “vertically” within the option chain. The idea is to selling the more expensive option and buy and less expensive option further out-of-the-money for protection. As a result, a credit is paid the moment the trade is entered. As the term “short” implies, this is a selling strategy and the max gain is the credit received. One could look at this strategy as simply selling a naked call or a naked put, but using part of the proceeds from the sale to buy insurance to define the trade’s risk.

Since this is a selling strategy, selling a call vertical would be considered a bearish trade, and selling a put vertical would be considered a bullish trade. Thus, short call verticals are often referred to as “bear call spreads”, and short put verticals, “bull put spreads.” The maximum gain (the credit received) is achieved when the options expire worthless at expiration. Here is an example of how to setup a short (bullish) put vertical up on SPY for April with SPY priced at 128.68

Sell   APR   124 Put  @ 1.90 (credit)

Buy   APR   122 Put  @ 1.43 (debit)

Net Credit: $0.47 per share

In the above example, if SPY closes above 124 by the third Friday in April the options will expire worthless, and the credit of $0.47 will be retained. The maximum loss would come if the stock is below 122 by April’s expiration and both options are exercised producing a $2 loss per share minus the $0.47 credit received. Thus, the maximum potential loss is $1.53 if SPY expires below 122. In between 124 and 122 a partial loss will be experienced. Since the stock is currently trading above the strike sold, a better the 50% probability is achieved since the stock can decline over $4 and still achieve max gain. An important note is to not allow the short option to expire in-the-money when the stock in between the strikes chosen. This will result in becoming long the stock, in this example, following expiration.

Here are a couple of qualities that are important when considering a stock to sell short verticals. First, liquidity is pre-eminent since it is easy to wipe out any perceived advantage by trading options with a wide bid-ask spread.  Second, the wider the distance between the strikes of the vertical, the lower the ROR for the trade. For example, a stock trading at $50 with $5 spreads between the strike prices would be less than optimal and generally provide a lower ROR for the same probability of reaching max gain.

The above is intended to get you pointed in the right direction when considering short verticals as a strategy. This can be a great option trading strategy when taking a moderate stand on direction, while generally maintaining a smoother profit curve.

When evaluating whether to purchase a program or not it is important that you attempt to find out what type of background the group has that is selling the educational product. This may seem easier than it really is. Every provider has a story to tell and may often tout their performance as being their primary qualifications. Even if someone presents themselves as a former floor trader it doesn’t mean that they have the skill to trade options as a retail investor. Do some searching for comments about the provider in regards to their abilities to instruct and whether they were able to reasonably apply the strategies being taught. Don’t focus as much on the comments about returns. The issue with focusing on whether something “works” or not is that it takes your eye off the ball. You want to learn how to trade options, and ultimately it is YOU that determines whether something works or not. You don’ know how well those individuals executed a particular strategy, whether their position sizes were appropriate, etc.

A trend over the last many years is to tie option and other related education to a broker. This can be a more cost effective solution if you have more considerable assets. Many firms will give you credits toward their educational products for transferred assets. Going this route has its advantages since you’re more likely to get what you pay for. If you contract with a third party provider they won’t generally have as strong of backing and tend to go out of business more regularly. While the product offering, cost and quality of their offering may generally be higher than your typical third party provider there are some downsides. The most significant is that brokers will have more stringent compliance. While having some sort of compliance policy is important, at that level it dictates the types of strategies discussed, what types of rules that can be implemented, etc.

For most investor education consumers, cost is the number one issue. You have to remember that it is a costly business to provide any substantive level of educational service. You’ll find many programs priced around $2000-$3000, and it is not by mistake. That tends to be a price level that people feel that they’re getting substance, but yet is a reasonable amount to part with. If you’re paying that kind of money for educational materials and possibly a newsletter for a period of time you’re probably being over-charged. Realize that most of these providers aren’t doing anything different, but if the cost is low enough it may be worth a look. If you’re paying for someone to be a guru for you as opposed to providing option education, just subscribe to their newsletter and see how it works. However, if you’re serious about learning the markets, the quality of the educational offering for the cost is of utmost importance. Lastly, make sure you’re not going into debt to purchase an educational program, and at least have sufficient funds to invest beforehand. If you pay $5000 for education and you’re starting with $1000 in a margin account, you probably weren’t in a financial position to purchase that level of education. Don’t get caught in the trap of needing to make your money back quickly, no matter the quality of education you’re likely going to make mistakes and lose.

Hopefully the preceding comments help you on your journey for a solid options trading education. Remember, in the end, it takes discipline and work on your part, but finding a helping hand can be beneficial to getting where you need to go.

Unfortunately, buying stock alone will make it difficult to be right a high percentage of the time. A stock has a 50/50 chance of moving one way or the other, and the minute you attempt to restrict its movement, with some sort of exit strategy, your odds can go down from there. High probabilities are achieved through option trading where the stock can move against you yet still allow you to profit.

While options are a means to maintain a high probability of success, all option strategies will not yield the same result. High probability option trading involves strategies like short out-of-the-money verticals, calendars, iron condors, etc. that place the trader in a position to profit even if they’re wrong on the direction of the stock or possibly the timeframe. Even incorporating things like implied volatility analysis can help one decide which strategy might provide the better odds. Also, using multiple strategies on the same underlying can help traders determine how often they want to be right over time and the accompanying reward/risk. There are laws of the trading universe that lower the ROR as the odds are increased. If you’re looking for unlimited potential gains on any given trade, go buy an out-of-the-money call or put option and see how you do over time.

What high probability option trading provides is a home for those that want leverage, satisfy the need to improve proficiency and smooth out returns. We’re not all pure speculators, and as such, many will find a home with a portion of their portfolio using this style of investing. Hopefully the topics discussed here will put you a little closer to finding your identity as a high probability trader.

In Figure 1 you’ll find a chart of the S&P 500 Volatility Index (VIX). As the VIX spiked to a 42 handle there is opportunity to take advantage of the panic. A high probability trade that can capitalize on high implied volatility and will make quick money on a sharp bounce-back are short put verticals. A short put vertical entails selling a higher strike price that is out of the money and buying a strike price that is lower than the one sold. Last Thursday a May 109/107 short put vertical could have been entered on SPY for about $0.40. This trade would have entailed selling the 109 put for May and buying the 107 put. The maximum gain in this trade the $0.40 credit received and the maximum loss would be a $1.60. The max loss is calculated by subtracting the the credit from the difference in the strike prices.

Figure 1–VIX Reaches 42%

This trade could have been closed for more than 50% of its maximum gain the following Monday following the Euro-zone bailout for Greece. Alternatively, this could be held toward expiration with a likely chance of taking home near maximum gain. This view is very contrarian to the panic that is ensuing and allows one to capitalize while still placing yourself in a likely position of winning even if the market doesn’t make an appreciable turnaround. Taking a short on the crash would have likely resulted in a loss had it been held over the weekend, and a long taken last Thursday may have resulted in a loss with the weakness last Friday triggering an exit or stop.

Several days ago there was a post made on Minyanville.com for playing a possible sell-off. There were three strategies discussed: puts, ratio back spreads, and long verticals. I don’t know much about the “Option Smith” other than the last article a I reviewed from him that was completely incoherent. However, this does a good job at providing some considerations for how to approach these trades. Below I want to provide some considerations for choosing the “best” trade for a given circumstance.

http://news.moneycentral.msn.com/ticker/article.aspx?Feed=MY&Date=20100408&ID=11385181&Symbol=IBM

1. Does the strategy fit your profile as a trader?

Ultimately you need to trade within yourself. A lot of new traders want to know what strategies “work” rather than which strategies work for them. If a trader primarily likes the high probability aspect of option trading, but decides to take a big bet by buying single options, they will likely make mistakes. I see it all of the time. They buy call or puts and tweak their system in order to be right a lot. The net result is to take limited profits, but allowing for large losses. The result is a system that has a lopsided risk/reward. It will work for a while as the market is directional, but things quickly turn and they give back their gains and then some–fast. I’m sure that there are many in this position right now, but don’t really know it–yet. Know yourself, and whether you like the idea of higher probability or speculation. Whether you have time to be active or comfortable making adjustments. Identify strategies that match your profile based on your interests in trading. I think you’ll find more success in the end.

2. Trade your Outlook.

This article does a good job at characterizing long options. If you approach long call and put options from the point of view that you’ll be wrong more often than you’re right, you put yourself in a frame of mind to make these trades work. Unfortunately too many traders think that if they use technical analysis that they will be able to turn the odds in their favor. I believe that this partly true, but  not in the way people think. Technical analysis is key in your ability to determine direction, targets and timeframe–all of which are critical to success. This provides an edge, but that does not mean that the odds will be turned on its face and you’ll be right a lot.

Having an awareness of the low probability of making money will naturally lead you to wanting a better risk/reward situation when buying options. Whether or not you need a 2-1 or 3-1 depends on a lot of factors, but one things is certain, you need to expect to make more than you plan to risk. The number he threw out was 15% for IBM, but realize that because of the differing volatility levels of stocks the opti0ns themselves are priced differently. In the end, run the numbers.

Tying this back to trading your outlook, larger projected moves and higher R/R would naturally favor the long put trade theoretically. If you’re expecting the market to drop, but want to provide some opportunity for gain if the trade goes against you significantly do the ratio back spread for a credit. If you want to make a purely directional play with a small amount of risk you’ll want to do the vertical.

Putting it together

In theory you can determine your target, timeframe, expectations for future implied, etc. However, balance that with what you trade best and execute consistently. You may see great opportunity based on your analysis, but if you haven’t tested or have a detailed plan for trading a strategy, consider doing something different. For example, if you prefer high probability approaches such as selling vertical spreads and find a theoretically opportune time to buy a put without having traded one previously–trade the vertical. If you see an opportunity to do a ratio back spread and typically lack patience due to your speculative nature, trade the put if it makes sense.

Although I make these points about balancing the idea of trading within yourself and matching the strategy with your outlook, that’s not to say you cant work on making other strategies your own as well. If you “own” a strategy you’ll make sure that both of these points are in place, which puts you in the best position to be successful.

Many traders probably find themselves wanting to make an adjustment just because the stock is moving toward their strikes, but it is important to know how probable an event like that will be. In Figure 1 you’ll see a P/L graph for a 113/119/126 May put butterfly on SPY for a debit of $2.38. The graph shows the potential range of profitability between 115.38 & 122.62 with the probability of finishing in that profitability range of 39%. We know from that data that the potential for making a profit is rather small, but the potential maximum gain of $3.62/share is much greater than the maximum loss of $2.38. The profile of this trade is that of lower probability and higher reward. However, those that make frequent adjustments are trying to make it a high reward and high probability trade, but how practical is that?

Figure 1

Let’s say that I planned to adjust this trade by rolling one of the verticals if the stock touched my break-even. In Figure 2 you’ll see the probability that each of the break-evens will be touched by expiration. The probability for the stock touching the lower break-even is approximately 68% and the probability of the upper break-even being touched is 53%. What this is implying is that the chance of having to make an adjustment is almost certain, and there isn’t an insignificant chance that both break-evens could be challenged and cause an adjustment to be made. In the end, it’s almost impossible to draw any conclusions from the initial probability of expiring number since the initial trade has little of standing as it approaches expiration.

Figure 2

Here is the point I’m trying to make with adjustments. I understand that some traders want to have a higher potential gain from the outset if things go according to plan, but are willing to sacrifice a part of that gain should the initial projection for the stock be wrong. That is certainly a reason for not entering the trade with a higher probability of success by skewing the butterfly. However, a simple adjustment based on the stock touching a certain price doesn’t necessarily allow for the stock to do what you want it to. It is the fact the probability of touching your break-even is much higher than the odds of it expiring beyond it that complicates things. Inevitably, most of those profitable opportunities would have been adjusted, the risk increased and the reward diminished. This makes it an important consideration to decrease the sensitivity of your trigger to make an adjustment.

I was just watching testimony of Alan Greenspan before Congress in his attempt to remove any culpability for the housing crisis. He brought up securitization and the expansion of sub prime mortgages as the major reason for the bubble. I understand that these products enabled the expansion of loan origination, but let’s get real, there wouldn’t have been near the amount of loans if interest rates weren’t allowed to remain artificially low for some time. Here’s my attempt to balance the rhetoric.

One interesting point I wasn’t aware of was the revelation made by Fannie Mae in September 2009 regarding the sizable amount of sub-prime mortgages they held at the time the music stopped in 2008. I heard a number that as little as 25% of their portfolio was actually traditional 30-year fixed, single family mortgages. During 2005-2007 Fannie and Freddie accounted for about 40% of all loans originated during that period. Another point to make regarding their role in the crisis is the fact that the implicit backing of the U.S. government allowed their borrowing rates to be much lower than what a free market would have assigned. The demand for their debt and the packaging of their debt with others of lower quality helped expand the prevalence of the mortgage-backed securities market.

There is a lot of blame being passed around for the “shadow banking system.” This comprised of debt that was securitized and sold in what turned out to be a fairly illiquid market. In Wikipedia there is a reference to Paul Krugman in which he supposedly said that the shadow banking system was at the “core of what happened.” Think of it this way, what if all of that debt was actually held by the banks instead of being dispersed globally? The result would have been much more disastrous for our banking system. One might argue that banks wouldn’t have originated that many loans if they intended to hold onto them. That may or may not be true, but were those purchasing these securities that much more ignorant than those running the banks. In short, no. The reality is that there was a tremendous desire for yield on investments. Fund managers leveraged themselves in order to buy a higher guaranteed rate of return. That guarantee that led to the high credit rating for mortgage-backed securities was the addition of Fannie and Freddie debt to the packaged loan security–which was implicitly backed by the Federal Government. In the end, the process of securitization helped to limit risk, but it was the distortion created by a low yield environment, Federal guarantees, and inept government cartel of ratings agencies that provided the fertile ground this market to grow.

Lastly, I would like to address Greenspan’s continued comments about his role as Chairman of the Federal Reserve. Certainly Fed interest rate policy has a much larger impact on short term interest rates, but short term rates still create a baseline with which long-term rates are based. There is a very predictable interest rate spread between yields for short term Treasury debt and that of longer maturities. That spread may vary, but there is little chance that long term yields will rise beyond a certain point without a move by the Fed. The Fed holding the line with irrationally low rates allowed for mortgage rates to remain low for a long time. That is only one facet of the impact their policy has on long-term Treasury rates, but there are others that promote trade deficits–which helped suppress long term Treasury yields due to foreign purchase of our debt.

http://www.minyanville.com/businessmarkets/articles/options-leaps-collars-january-expiration-strike/3/31/2010/id/27567

The profit curve for this trade isn’t as clear as it seems, and I have no idea where he’s getting his numbers. There was a typo for the put premium he paid and so I’m assuming the Jan 220 put was purchased for $20 and the Jan 260 call was sold for $19. The  net cost on this position is $26 since the premium from the Jan 260 call is used to purchase the Jan 220 put fora $1 debit, and the Oct 230 call is purchased for $25. Since the Oct 230 is purchased their isn’t technically any gain on this stock until it’s over $300. Let’s assume that e meant to use a Jan 230 call and that he could have purcahsed it for $25. The maximum gain on this trade is $4 at expiration and is calculated by the purchase of the stock at $230 and the sale at $260 minus the $26 cost. He mentions a $25 credit from the collar, but he says that he sold the 260 call for only $19.

Assuming the Jan long call instead of October, the risk and reward was completely off in this article. If the stock trades between $220 and $230 at expiration the risk is $26 a share and not $15. I’m getting dizzy trying tomake sense of it, and so I’m going to stop before I throw up.

Here is a P/L graph if this trade was constructed day using all Jan options. I entered several price slices to reflect the loss at expiration. An October 230 long call would only look moderately better. The issue with this trade is that an ATM call option is purchased and the collar can’t be enteredfor a credit.