The vertical spread is one of the best options trade for beginners, and is also the best all-around options trade for anyone who would like to control risk. And controlling risk, my friends, is the key to success as an options trader. A vertical spread involves the simultaneous buying and selling of options of the same type (puts or calls) and expiration at different strike prices.
The vertical spread is versatile.
You can use it to short the underlying equity aggressively buy purchasing a put spread, or less aggressively by selling an out of the money call spread.
You can “buy” or go long on the underlying equity aggressively by purchasing a call spread, or more conservatively, by selling an out of the money put spread.
The choice you make should depend on a number of factors, but most importantly, implied volatility. When implied volatility (IV) is high, the options will cost more than usual, and you can sell them for a higher premium. When IV is low, the options will be cheap and you can buy them for a good price.
90% of my trades are vertical spreads.
Short Put Vertical
In this example, $MU is trading at $57.76. If we sell the $57 put and buy the $56 put, we collect $38, with a 60% probability of profit. We are risking $62 if the trade goes against us, meaning, if the value of $MU moves below $57. If $MU stays at its current price, increases in price, or drops, but stays above our $57 strike, we will keep the full $38.
I like to close my trades at 50% profitability, so I would close this trade when I can buy it back for half of what the premium was worth when I “sold” it, or $19.
This is a great trade for when you think a stock is going higher long-term, but aren’t confident it will happen in the short term. You think it will hold its value or go higher.
What if the value of $MU drops below $57? You can 1. wait and see if it goes back up prior to expiration, 2. close it and take the loss, or 3. roll the trade forward to a later expiration, and try to “wait it out”. This is the technique used by investors who don’t mind having their capital tied up for longer periods of time.