When youíre trading options, especially if youíre a beginner,
you may lean toward single options strategies like long calls or short puts
because you only have to manage one option. But these strategies have some drawbacks.
With long calls you have to correctly predict short-term stock behavior, which isnít easy. Naked
puts carry substantial risk, and cash-secured puts can tie up a lot of cash in your account.
These drawbacks are why some strategies combine multiple options contracts. These are called
spreads, and theyíre popular because they allow you to define your risk and reward.
There are many ways to combine options into spreads based on your goals and risk tolerance.
Weíre going to focus on one of the most common: the bull put spread, or as we like to call it,
the short put vertical. This bullish strategy is known by several different names,
such as a credit put spread or short put spread, but itís a basic concept: You sell one put to
potentially profit from a stock going up, but also buy another put at a different strike,
which provides protection in case it doesnít. This allows you to define your risk and your reward.
Iím Education Coach Cameron May, and Iíve been teaching traders about options for 15 years.
Combining multiple options together in one trade can seem complicated, but
weíre going to walk through all the ins and outs. Weíll break down how the short put vertical works
and how to set it up on thinkorswim Web, our browser-based trading platform.
Itís got a lot of the powerful options trading tools of thinkorswim desktop
but in a simplified interface you can access just by going to trade.thinkorswim.com.
Weíll assume you already know the basics of options trading and the greeks. If
youíre an absolute beginner, check out our other videos to get your bearings on options basics.
So. Short put verticals. This is a bullish strategy that involves
simultaneously selling an out-of-the-money put and buying another put with the same
expiration thatís further out of the money. The short put is the driver of the trade. It benefits
from time decay and when the underlying stock goes up, while the long put hedges your risk.
Youíll have to pay the premium for the long put, but that part of the trade is
usually cheaper than the short put, so youíll wind up with a net credit from the get-go.
Keep in mind, youíll still have to pay transaction costs. The ideal outcome is for the stock to stay
above the short put so both options expire out of the money. That way you keep the premium
you received when you entered the trade. If things donít go your way and your short
put is assigned, you can exercise the long put to deliver on your obligation
to sell the underlying stock at the strike price. Itís also possible the stock could end up between
the strikes. This can be a tricky situation, and weíll walk through ways to handle it later.
But now that youíre familiar with the basic mechanics of the short put vertical,
why should you consider this strategy? Consider risk versus return.
As long as you play your strikes right, thereís a relatively high probability of being profitable.
Letís look at the strategyís risk profile to see how this works.
This is the risk profile of a short put. This will be your main profit driver. In order for it to be
profitable, the underlying needs to stay above the break-even point, which is the strike price
minus the premium. If it drops below the strike price, you run the risk of getting assigned.
Compare that to the risk profile of a long put, your hedge. You can see the risk is defined.
Put them together and you can see both the max loss and max gain are capped. This is what I
mean when I call this a defined risk and reward strategy. Youíre basically capping your potential
gains in return for defining your maximum loss. This strategy can offer a higher probability of
success than other bullish strategies like long calls because unlike bullish single options
Strategies the underlying stock can go up a lot, it can go up a little, it can go sideways, or it
can even go down a little, and the trade can still be profitable. This offers a lot of flexibility,
letting you manage how much profit youíre willing to trade for what probability of success you want.
There is a trade-off that comes with that higher probability of success:
You limit your potential profit. To get a sense of how these really work together,
letís look at an example. Letís say youíre bullish on stock XYZ, and itís currently trading at $99.
You think itís going to hold steady or move up slightly, so you sell a put 40 days from
expiration at the 97 strike for $1.50 premium, or $150 for the contract, and you buy another put on
the same expiration further out of the money at the 95 strike for $60 per contract. With these two
options combined, your net credit for the spread is $90, (or $150 minus $60), minus transaction costs.
Letís say youíre right, and the stock does increase slightly, up to $101 near expiration.
A bullish move is the best-case scenario here. Both options would expire out of the money,
leaving you with your $90 credit, minus commissions and fees. Weíll talk about how
to manage a trade like this a little later on. But what if the flipside happens, and the stock
moves down instead? Letís say the stock drops and is trading at $93 at expiration. If that happens,
your short put is assigned, meaning youíd have to buy 100 shares of the underlying.
But you bought that long put for exactly this possibility. Because you bought the long put
for a lower strike price, youíll only be out the distance between the two strikes.
Letís break that down by the numbers. Your short put would cost you $9,700 to buy the 100 shares,
but the 95 long put would let you sell the shares for $9,500, leaving you with a $200 loss.
Remember, you sold this spread for a net credit of $90, so that would offset this a little for a
total loss of $110 plus transaction costs. No matter how much the stock drops it could drop
down to $50 per share or lower that $110 is the most youíll lose on this spread.
But what happens if the stock winds up somewhere in between your two strikes?
Youíll have an in-the-money short put and an out-of-the-money long put.
Depending on factors like the stock price and how you decide to exit the trade, the trade could
ultimately still be profitable, but it might not be. Whatís most important is that youíre at risk
of being assigned stock because of the short put. If the stock does end up between the strikes,
youíve got a couple choices. You could let the trade expire and get assigned 100 shares of stock.
But because your goal is not to enter a stock position, youíll probably want to take some
action, like closing the trade. Consider closing both the long and short puts. While the short put
is the one with assignment risk, closing the long put at the same time can lock in
any remaining premium in the long put, which could help offset a loss on the short put.
Keep in mind, both of these would incur transaction costs.
Now that youíre familiar with potential outcomes of a short put vertical, letís take a quick
look at what forces impact the value of the options. These are price, time, and volatility.
The first force is price and is measured by delta. Short put verticals are delta positive,
which means premiums fall as the stock price goes up. As the option seller,
you want this to expire worthless. This greek will give you a sense of how much
the options contract price may change with a $1 move in the price of the underlying.
The next force is time. Theta measures the impact of time decay on short put verticals.
Because the driver of this trade is a short put that you want to expire worthless,
itís theta positive. Remember, the max gain for this strategy is the premium
you collected when you first placed the trade. The last force is volatility. Vega tells you
how rising or falling implied volatility could impact your options trade. Short put verticals
have negative vega, so, ideally, youíd like to see volatility hold steady or fall.
This makes sense because your ideal outcome is for both options to lose value and expire worthless.
Now that youíve got the basics, letís make some paper trades.
Iíll log in to thinkorswim Web. Here you can see all the accounts and positions,
and that Iím in paperMoney, which allows me to place simulated trades without risking real money.
Iím going to close this sidebar to give us some more room.
Ok, so our first step is to choose an underlying asset we want to trade. For this strategy,
we donít need to own the stock, but we do want to make sure itís following some entry rules.
Because this is a bullish strategy, consider highly liquid assets that are already in an
uptrend. Of course, thereís no guarantee that the upward trend will continue, but it could
increase your probability of success. You could set up a watchlist of stocks to keep an eye on.
Next, weíve got to determine when to actually enter the trade.
Technical analysis can help. A chart pattern like a bounce off a price floor or a break through a
price ceiling could be a signal that a stock is potentially ready to make an upward move.
For today weíll use Expedia, symbol EXPE, as an example. Hereís its 6 month daily chart.
You can see itís in an upward trend. Let me draw a trendline here to show what I mean.
You can see there was a recent price ceiling around 145.
Iíll draw another trendline here, so we can see that itís broken through that ceiling.
So, we know what stock we want to trade, now weíve got to choose our options contracts.
To do that Iíll scroll up and open the option chain.
Up first is selecting an expiration. For a short put vertical, the goal is to hold it to expiration
and stay out of the money. There is a trade-off at play here: We could choose an expiration thatís
closer, which would mean faster time decay but less premium overall. Further out could provide
more premium but slower time decay. For a good balance, Iíll aim for an expiration thatís 15
to 50 days out. So, in this case, weíll go with the March 19 expiration, expiring in 36 days.
Next up is choosing the strikes for our short and long puts. Again, this is a trade-off. One
way you adjust the trade-off between probability and profit is how far out of the money you go with
that strategy. A common mistake is staying too close to the at-the-money strike in pursuit of
higher potential profit or going too far out of the money for higher probability,
which significantly limits profits. For our short put, weíll look for a delta between .30
and .40. Ideally, this strike price is at or below support levels, which could mean the stock is less
likely to fall below our strike. We can see the 140 strike has .32 delta and is below support.
This will give us a good shot at the option expiring out of the money while still providing
a decent amount of premium. It also looks like the difference between the bid price and the ask price
is less than 10% of the ask price, which suggests good liquidity. So letís plan to sell that one,
so Iíll click the bid price. You can see itís entered at the bottom of the screen.
Now, we need to choose the strike for our long put. This strike should be below our short put.
Thereís another tradeoff here. The width of the spread determines how much credit weíll receive
for selling it. But the wider the spread, the more risk you open yourself up to because your max
loss is the distance between the strikes. One common rule is to choose a long put at least
$2 below the short put. For us, the next available strike is $5 away, at 135. Itís allowing us some
breathing room. Iíll click the ask price. Youíll notice our order now says vertical.
Letís scroll down and look at it. So, here in the order editor I can see Iím selling the March
19 140 and buying the March 19 135. Now youíll notice the price of our spread is still moving.
Letís lock our required credit to a limit of 165. And weíll leave the time in force at day.
Now we can figure out how many spreads to trade. To do this, you need to know two things:
your portfolio risk and your trade risk. Portfolio risk is the total amount of your portfolio youíre
willing to lose on a given trade. Consider setting aside no more than 1% of your active
trading portfolio per trade. So, for simplicity, letís say Iím trading with a $100,000 portfolio.
If Iím willing to lose no more than 1%, my portfolio risk would be $1,000 per trade.
Trade risk on the other hand is the amount you could lose in a given trade.
For a short put vertical, the trade risk is the distance between the two strikes
(think short strike minus long strike) minus the credit you received from the spread.
In other words, the spread width minus the credit. For this trade thatís a $5 wide spread, or $500
minus the anticipated credit of 1.65, or $165, for a trade risk of $335
Now that we know our portfolio and trade risk, we can figure out how many spreads to sell.
To do this, take your portfolio risk and divide it by your trade risk.
So, our portfolio risk of a 1,000 divided by the trade risk of $335 equals just about 3 spreads,
which Iíll enter in the trade ticket. Now that weíve got our trade loaded up,
letís do some quick analysis using a nifty feature on thinkorswim web.
Below the order ticket youíll see a stock chart and a risk profile chart.
On the stock chart you can see two tabs representing my strikes, and where they
fall in relation to the stockís historical price. You can also hover your mouse over either chart to
get a sense of where a given underlying price would fall on the other. In the risk profile,
the curved dotted line represents how different prices would impact my profit or loss today,
while the green and red boxes represent at expiration. For example, we can see our
breakeven for today is approximately 150. However, at expiration, due to the effects of time decay,
itíll be about 138 and half, 138.35 to be precise, not accounting for the transaction
costs. You can see the stock being anywhere above there at expiration would be profitable,
though once we reach 140 both contracts expire worthless and we hit max gain. In the other
direction, anywhere below 135 at expiration, both options would be in the money and Iíd hit max loss
Letís go back up and place the trade. Iíll click review and confirm the details are
correct. Note the transaction fee, in this case 3.90, or .65 per contract. Now Iíll click send.
Thereís the confirmation saying our orderís been sent. Ok, weíve placed a short put vertical!
But this isnít a set it and forget it kind of strategy. Weíve got to make sure weíre keeping
up with it. The way you manage these trades can make or break them, so weíre going to
walk through managing some other sample short put verticals that Iíve got in a paperMoney account.
But before we go through them, letís talk about a simple rule that can guide how you manage your
short put spreads: If youíre more than five to 10 days from expiration, manage your winners.
If you have less time than that, manage your losers. Let me explain what I mean. Set a profit
Target this could be something like 80% to 90% of the max gain and then close your winners when
they reach that target, even if itís just a few days after youíve placed the trade. If you get
to 10 days before expiration, start weighing whether you should exit your losing trades.
Letís open up Nvidia, symbol NVDA. Both of our strikes are out of the
money. Our original credit was 4.09, which is our maximum gain.
Our current unrealized gain is around $400, leaving us with only about $9 of remaining profit.
We could let it ride and leave it open for an extra 9 days, but that opens us up to the
risk of it turning downward, and we could lose out on some gains. Since weíve already
achieved 98% of our max gain, Iím going to close this trade to lock in that profit.
To close the position Iíll click the symbol, which opens up more details.
The position is already selected, so I can click close selected to bring up the order entry.
So you can see Iím selling the long put and buying the short put for a debit of
8 cents. Iím going to nudge that to 9 cents to increase my likelihood of getting filled.
Now Iím going to click review, where I can see the cost of the trade, which includes $1.30 in fees.
Ok, letís go back to our positions and take a look at another one. Iíve got a spread on Union
Pacific, UNP, and you can see both options are in the money. This is looking like a likely max
loss scenario, and the risk of early assignment on my short put is elevated.
But Iíll give it one more day in hopes itíll turn around and I can avoid max loss. Remember,
if both options were to expire in the money, my long put would help cap the loss on the short put.
In any event Iíll close it tomorrow, whether weíre further from max loss or closer to it,
in order to salvage any remaining value before expiration.
Alright, letís look at one more sample trade to answer the question, What happens if the stock
lands between my strikes? So, on Pepsi you can see I sold the Feb 12 142 put and bought the Feb
12 137. Iíve only got 2 days to expiration, and the stock is now just above 137, so the short put
is in the money, but the long put hasnít been hit yet. Weíre facing a potentially tricky scenario.
I havenít hit max loss yet, but Iím definitely at risk of assignment on the short put and my
long put is still out of the money. If we hit expiration in this scenario, the short put will be
assigned, but the long put would expire worthless, leaving us on the hook to buy 100 shares that we
never intended to own. So, to avoid assignment, Iím going to close the position for a loss.
Iíll follow the same process as my earlier trade that was a winner: click the symbol,
click close selected. Iím going to leave it at the mid price and review the details, which show Iím
buying the vertical back at a cost of $350. At expiration it could have cost as much at $500,
so Iím preventing a max loss. Note the transaction fee of $1.30. Now Iíll click send.
There you go. Thatís the nuts and bolts of the short put vertical.
Or the bull put spread. Or the you get the idea.
Remember, even though the approach we discussed may be higher probability
and less risky than others youíve seen out there, itís still risky. Make sure
you practice paper trading to get a feel for how these trades can move.
Be sure to check out our coaching webcasts too. We have lots of options education that you should
take advantage of because management is such a huge part of trading options.
To try out thinkorswim Web, visit trade.thinkorswim.com.
If you want to practice, make sure you switch to paperMoneyÆ in the
top left corner to get a handle on how vertical spreads work.
You can also download the full thinkorswimÆ software,
which weíve linked to in the description. We have a ton of other education on our channel,
so make sure you subscribe and hit the bell to get notified when we upload new videos.