With so many possible vertical spread combinations singling out the best one is mind numbing, to say the least. Using these steps can help simplify the process and create confidence that major factors haven’t been ignored.
Vertical spreads are straightforward enough for those initiated to options trading. Let’s say a trader is bullish on an underlying. The Bull Call vertical or Bull Put vertical would be ideal. Conversely, the trader may expect poor performance in the coming days. Therefore, the Bear Call Vertical or the Bear Put Vertical would be more appropriate.
Simple enough, Yes? But there’s still questions that must be answered and I’ll attempt to uncover the lions share of them below.
Vertical Spread Step-by-Step
Step 1 – Check IV Percentile or IV Rank
This metric will answer a very important question. Should I buy or sell a vertical spread? If IV is “relatively” high the better option is to sell the vertical spread. Conversely, when IV is “relatively” low the better option is to buy the vertical spread.
This metric will also benefit the astute trader by answering another question. Are the option premiums dense or light? Dense meaning, higher premiums and light representing lower premiums. With an understanding of IV Percentile or IV Rank you won’t, generally, have to worry about overpaying or under receiving on the premiums.
Word of Caution – Understand, IV can stay high or stay low.
Step 2 – Determine Underlying Direction
This step will require the trader to determine a directional bias for the desired underlying. Honestly, this section could and does comprise entire books. Therefore, I’ll simply defer to you to determine the best method. I have my own but that isn’t the purpose of this post. The easiest method would be simply to use a moving average crossover strategy. Possibly, the 10 SMA crossing the 30 EMA for short term trends.
Step 3 – Days to Expiration
Now the question is…How Long? Honestly, the only way to answer this would be to have a crystal ball but the reality is just as simple, choose enough time for the position to have a reasonable chance.
To do this, consider adding the average true range indicator to your charts. This tool can help improve the odds of success via some basic arithmatic and some rudimentary forecasting.
I use the ATR over a 200 period average. To add and adjust ATR in ThinkorSwim, click the beaker icon > Search ‘ATR’ > Double click. This will add it to your subcharts. Click the associated gear icon to open the indicator settings > Change the length field to 200 instead of 14. This uses a larger number of days to determine a more normal average by smoothing some of the extreme moves.
As you can see in the image above, ATR is currently at $4.74. That suggests that the daily range for each day over the last 200 days is $4.74. With this information we can guesstimate a reasonable amount of time.
For instance, if a trader selected the expiration month ending in 30 Days. Simply Calculate.
$4.74 * 30 = (+/-)$142.2
So if price moved entirely up or down everyday for the next 30 days the underlying price would move $142.2 points. However, this isn’t likely to happen. Therefore, to account for some arbitrary level of variance we need to multiply by our assumption price will maintain a directional bias. In this case, I’ve suggested price will move directionally only 25% of the time over the next 30 days. Calculate.
$142.2 * .25 = (+/-)$35.5
This solves the problem of price going straight up or down using a random blind assumption.
However, I’m certain more scientific approaches exist so if possible refer to that. This suits me well and its quick to uncover.
With this information a trader can now determine with some confidence if 30 days will be sufficient. How? By comparing the amount of our hypothetical expected move to the desired or non-desired move of our selected spread.
I’ll put this, along with all the vertical spread pieces, together again at the end of this post.
Word of Caution – If in doubt allow for more time to expiration.
Step 4 – Vertical Spread Strike Selection
Vertical Spreads are comprised of 2 different strike contracts. One long, one short. At what level each falls rests on the directional assumption and IV.
For example, lets assume we’re bullish on SPY over the next 30 days and IV is relatively high. Thus, a trader may wish to sell the bull put vertical spread and for this trade to be profitable it will need to expire out of the money.
But at what level should the short strike fall? This can be selected using the Probability out of the money(OTM) metric in ThinkorSwim. This mythical number can be used to determine, mathmatically, just how likely a strike is to finish OTM.
Word of Caution – This number is theoretical in nature and reality is often much different.
Then, using the Probability OTM highlighted above a trader is able to see the mathmatical likelihood an option strike will finish OTM. Therefore, it makes sense to desire a strike price further away with a higher chance of success.
Step 5 – Vertical Spread Risk
The final piece to the vertical spread puzzle is determining an appropriate amount of risk. Of course, to do this, the trader will want to consider his/her account size, risk tolerance, and confidence level the directional bias is accurate. Moreover, its that confidence in direction that can be problematic ;).
Once those questions are answered simply select the long portion of the vertical spread trade and execute the order.
Hypothetical Vertical Spread Example
Together with the examples discussed above. Suppose a trader is bullish SPY. Price is currently $264.86. IV Rank is 48, which is relatively high.
30 Day possible price movement = (+/-) $35.50
Short strike = $243 put (70% Prob. OTM)
Long strike = $242 put
By subtracting the current market price of SPY with our short strike price we can compare with the 30 Day move.
$264.86 – $243 = $21.86
We’re expecting a directional move of approximately $35.50 but our current trade only allows for $21.86 before breaking our short strike. Its at this point, the trader would have to rely on their directional bias to determine the viablity of the trade.
If confidence is high price will remain higher then all systems are a go to execute. Should there be any doubt, a trader would be well served to move further out in time or forgo the position all together.
Great! More Math…
$21.86 / $35.5 = .61 or 61%
In this instance, we can see there is an arbitrary 61% chance this trade will become profitable. Therefore, signaling a potentially positive trade. However, it could also make sense to look at future expiration months or alternative strikes to find a higher probability vertical spread.
May God bless and keep your trading profitable,
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