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A Little About Vertical Spreads:
Vertical spreads are known as directional spreads. When you place such a spread, you are betting that the stock will move in a particular direction, either up or down. If you are right, you can make a nice gain. Even better, you can usually create a vertical spread that also makes money if the stock doesn’t move in the direction you hoped, but stays absolutely flat instead.
If you have a strong feeling that a particular stock will move higher in the near future, you might be inclined to either buy the stock or buy a call on it. Both of these choices have disadvantages. Buying the stock ties up a great deal of money, and even if you are right and the stock moves higher, your return on investment is likely to be quite small.
Buying calls gives you great leverage and a much higher return on investment if you are indeed right and the stock moves higher. But much of the cost of a call is premium (the extra amount you pay out so that you don’t have to put up so much cash compared to buying the stock). The stock needs to go up a certain amount just to cover the premium, and you don’t start making money until that premium is covered. If the stock doesn’t go up (and no matter how great you are at picking winners, you will probably be disappointed many times), you could lose some or all of your investment. Bottom line, buying calls is a losing proposition much of the time – you have to be really lucky to come out a winner.
Buying a vertical spread is a safer alternative than either buying stock or calls. You give up some of the extraordinary gains for a great likelihood of making a more moderate gain, and if you play your cards right, you can also make a gain if the stock stays flat.
Let’s look at an example. Last week, my favorite underlying, SVXY, had been beaten down because VIX had shot up over 25. I felt very strongly that the market fears would eventually subside, VIX would fall back to the 15 level, and SVXY (which moves in the opposite direction of VIX) would move higher.
Late last week, when SVXY was trading right at $60, I bought November 55 calls and sold November 60 calls as a vertical spread. It cost me $3 ($300 per contract). When these calls expire in about a month, if the stock is any higher than $60, my spread will be worth exactly $5, and I will make about 60% on my investment. The interesting thing is that it doesn’t have to move any higher than was at the time for me to make that kind of a gain.
In reality, while I did make this vertical spread, I didn’t use calls. Instead, I sold a vertical spread using puts, buying November 60 puts and selling November 55 puts. I collected $2, an amount which is the exact same risk that I would have taken if I had bought the vertical spread with calls. The broker will charge a maintenance fee of $5 ($500) on each spread, but since I collected $200 at the outset, my risk, and the amount I had to put up, is only $300.
The risks and rewards are identical if you buy a vertical with calls or sell a vertical with puts (assuming the strike prices are the same), but there is a neat thing about using puts if you believe the stock is headed higher. In this case, if the stock ends up at the November expiration at any price higher than $60, both the long and short puts will expire worthless (and I get to keep the $200 I got at the beginning). There is no exit trade to make, and best of all, no commissions to pay. For this reason, I almost always use puts when I buy a vertical spread betting on a higher stock price rather than calls (the only exceptions come when the spread can be bought for a lower price using calls, something which occurs on occasion).
Update on the ongoing SVXY put demonstration portfolio. (We own one Mar-15 65 put, and each week, we roll over a short put to the next weekly which is about $1 in the money (i.e., at a strike which is $1 higher than the stock price).
This week, SVXY moved sharply higher, from about $57 to about $62. Today I bought back the out-of-the-money Oct4-14 59 put for a few cents and sold an Oct5-14 64 put (about $2 in the money) for a credit of $3.65 ($365) on the diagonal spread. The account value is at $1290, just a little higher than $1234 where we started out (we would have done much better if the stock had moved up by only $2 instead of $5).
I will continue trading this account and let you know from time to time how close I am achieving my goal of 3% a week, although I will not report every trade I make each week. I will follow the guidelines for rolling over as outlined above, so you should be able to do it on your own if you wished. This week I sold the next weekly put at a strike which was $2 in the money because I think the stock is headed higher because VIX is still at an elevated level compared to where it has been for the past year or so.
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Terry
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