One of the most popular option trading strategies and a building block of many high probability trades is short verticals. With the proper setup, these trades can provide a winning percentage of greater than 50%, and also provide limited downside risk. High probability and defined risk—what a beautiful combination! Let’s take a closer look at this strategy.
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.