Managing Vertical Spreads

December 12, 2018

So far in the early stages of this market correction (dare I say Bear Market? Too Soon?), I’ve been aggressively deploying Bear Call Spreads to attack bearish trading opportunities.

Bear Call Spreads are a version of a vertical spread that consist of a short call at or slightly out-of-the-money and a long call further out-of-the-money. The profit profile of bear call spreads typically maps out like this:

As you can see from the profile, the upside risk is capped at the long call strike (in this case, at $110). Risk is defined and the most we can lose in this trade is the width of the spread (110 strike – 100 strike) minus the credit we received at initiation. So, if we collected $3.00 when we put this trade on, the most we could lose is $7.00. And on the flip side, the most we can gain is $3.00 which happens if we hold this position to expiration and all options expire out-of-the-money and worthless, allowing us to keep the entire $3.00 credit we received when we put the trade on.

While this is a relatively straight-forward and basic options spread, there is some nuance involved when it comes to managing short vertical spreads that aren’t behaving the way we’d like them too.

Typically, when putting on a short vertical spread (Bear Call Spreads, for example) I seek to close the trade at a profit when I can close the entire spread (buy-to-close) for half of the premium I collected at initiation. So, using the example above, I would seek to close the trade when I can buy it back for $1.50 which equals half of the $3.00 premium I collected when I first put the trade on. Pretty simple.

Why not hold until expiration, especially if the stock has fallen and all the options are out-of-the-money? This is a common question that I get and the simple answer is — it’s not worth the risk. In the above example, lets say the spread can now be closed for $1.50. Yes, I can hang on for that extra $1.50, but doing so now exposes me to $8.50 of risk if the stock were to suddenly reverse higher. Additionally, it means I have to continue monitoring this position — maybe for a couple more weeks — trying to squeeze out those extra nickels. Meanwhile, the capital tied up in this position might be better deployed in new positions with better risk/reward profiles. This is opportunity cost.

And as we’ve all seen in this market, rallies higher in otherwise downtrending markets can be sudden, vicious, and fast. So I like to aggressively take profits when I have them, because they can evaporate in the blink of an eye in this current environment.

Where do you place your stop loss? This is another common question I get. And the short answer is, typically I do not place a stop loss. This is a defined risk spread and therefore I know the maximum loss I’m exposed to up front, and I accept that risk. It all comes down to position sizing. I always size a short vertical spread position such that if I take the full loss, the dollar impact to my portfolio is well within an acceptable limit. And this gives me the advantage of being able to sit patiently through adverse price movements and not get shaken out by noisy price action. This allows me to focus on executing my plan. This is an under-appreciated power in defined risk spreads.

Managing Bear Call Spreads That Need More Time

Inside 21 days to expiration, if we’re still holding this spread and we can close it for a small profit, I’ll likely just do that and move on. Gamma risk is going to start to noticeably increase as we approach expiration, meaning the position’s open P/L will fluctuate more dramatically with each up or down tick in the underlying. This becomes an unwanted distraction and emotional rollercoaster. Avoid. We’ll just take our small profit and call it a win.

But what to do with short vertical spreads that are stuck in the middle? They haven’t yet hit our profit target, the underlying is trading somewhere between our short and long strikes, and the open P/L in the position is negative. As we approach expiration (inside 21 days), we will want to look to take some action. In these situations, I’ll always look to see if I can roll the position out to a later expiration for a credit. The credit part is important. I will only do the roll if I can earn a credit for doing so because a credit reduces my net risk in the position. I’m not interested in increasing my risk.

To explain this better, lets use a real-world example from an actual position I’m currently riding to illustrate:

  1. Initiation: On October 25, we alerted All Star Options subscribers that we were entering a Bear Call Spread in Disney $DIS. On that day, $DIS opened trading around $112.50. We sold the November28 (weekly) 113/118 bear call spread (short 113 + long 118) for a $1.50 credit.
  2. Our profit target (75 cents) was never hit, and once we got inside 21 days until expiration, we were sitting on a loss as $DIS vacillated between $115 and $120 per share. Since this is a defined risk position, I patiently held on waiting for an opportunity to roll for a credit. That opportunity finally came on November 20th, the second of two days that saw $DIS fall from 118 to below 112. We were able to close the Nov28 113/118 spread and sell the identical 113/118 spread in December options for a net 11 cents credit. The credit was small potatoes, but nonetheless reduced our risk in the trade by 11 cents, and gave us another 3 weeks to let our thesis play out. With our new total net credit in this positions at $1.61 ($1.50 at initiation plus 11 cents from this roll), our profit target was now 80 cents.
  3. When the calendar turned to December and we were found ourselves inside 21 days to December expiration, our now December 113/118 spread still had not hit our profit target. Meanwhile, in January, the monthly options expiration cycle was only listing options strikes every $5. There were no 113 or 118 strikes for us to roll our position into. The nearest approximation was 115/120, but we couldn’t do that roll for a credit. No bueno. So we waited. Again, worse case scenario is we take a maximum loss, currently defined at $3.39 (5 – 1.61).
  4. Finally, on the week of December 10, I noticed there were now weekly options also being listed in January, and those expirations offered strikes at every dollar level. And with $DIS trading $110-$112 on Monday Dec 10, we were able to roll our December 113/118 call spread into Jan25 weeklies at the same 113/118 strikes for a nice 50 cents credit. This now brings our total net credit in this position to $2.11, reducing our net risk.

And this is where we stand now. Still riding the same vertical spread, only now our credit is $2.11 versus the $1.50 we originally received when we started this trade. And we’re looking to close this spread around $1.05 which is half of our total net credit. Hopefully we’ll get there this month. If not, we’ll continue rolling it out as long as we can continue doing so for a credit and therefore reducing our risk at each roll.

This is how I manage vertical spreads, and particularly Bear Call Spreads in this choppy market environment we find ourselves in as the end of 2018 approaches.

Happy Trading!

~ @chicagosean

If you’d like to try out All Star Options risk free, head here.