A vertical put credit spread is the simultaneous purchase of an ITM put and sale of an OTM put. The vertical put debit spread is similar to the vertical call debit spread. Vertical Call Debit Spread: Sale of an OTM call (greater than current price) and Purchase of ITM call (lower than current price) Vertical Put Credit Spread: Sale of an OTM put (lower than current price) and Purchase of an ITM put(greater than current price) There is no hard and fast rule of the two different options needing to be either OTM, ATM or ITM. Depending on the market conditions and your outlook, both options could be OTM or both could be ITM or you could have one ITM and other OTM. Here are the graphs for the vertical put credit spread: Just like the previous three vertical strategies, the bull put spread is an alternate name for the vertical put credit spread because profit is maximized when the stock price is ITM (greater than the original market price).
Profit: Maximized at premium collected. Loss: The loss is equal to the difference to between the ITM and OTM strike prices minus the premium received from the sale of the OTM put. Once again, the similarities between the vertical call credit spread and the vertical put debit spread are evident in the two graphs.
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Put spreads are not too different from call spreads but it is crucial to distinguish between ITM and OTM for each. Remember: For puts, ITM is above the current price, OTM is below the current price. For calls, ITM is below the current price and OTM is above the current price. A vertical put debit spread is the simultaneous purchase of an ITM put and sale of an OTM put. The vertical put debit spread is similar to the vertical call credit spread. Vertical Call Credit Spread: Sale of an ITM call (lower than current price) and Purchase of OTM call (greater than current price) Vertical Put Debit Spread: Sale of an ITM put (greater than current price) and Purchase of an OTM put (lower than current price) Let's analyze the graphs for the vertical put debit spread: (Will find better image)
As its alternate name implies, vertical put debit spreads are bearish, as you maximize your profit when the stock's price is ITM (or lower than the original market price). Profit: The maximum profit is equal to the difference between the original ITM and OTM strike prices and the premium collected. Loss: The loss is capped at the amount paid for the OTM put premium. Earlier, I mentioned the similarities between the vertical call credit spread and vertical put debit spread. If you look back to the vertical call credit spread, the similarity is much more clearer, as the graphs form the same shape! If you've understood the Vertical Call Debit Spread post, you are ready for the Vertical Call Credit Spread. The mechanics are the same: a simultaneous purchase or sale, ITM or OTM, for the same market price. Where the Vertical Call Debit Spread was a purchase of a ITM call and sale of a OTM call, the Vertical Call Credit Spread is sale of a ITM call (lower than the current price) and purchase of a OTM call (greater than the current price). Let's look at the individual components of the trade, and the graph of the spread: From the graph, we can identify that we maximize our profit when the market price of the stock is ITM, or lower than the original market price. Our bearish assumption, non-coincidentally, coincides with the alternate name for the vertical call credit spread: bear call spread.
Profit: The maximum profit we can obtain from this trade is equivalent to the premium collected from the sale of the ITM call. Loss: The loss is still capped. In the case of the vertical call credit spread, however, it is equal to the difference between the ITM and OTM prices and the premium collected. In the graph's example this is: ($40.00-35.00)x100 minus the premium ($2) x100. Now, with vertical spreads, we are working with more than one option. A vertical call debit spreads is the purchase of a call at a price lower than the current price (ITM) and the sale of a call at price lower than the current price (OTM). The key to vertical spreads, in that the purchase and sale of the option is simultaneous, meaning that the ITM and OTM assumptions are relative to the same market price. To visualize the spread, let's revisit the graphs for buying and selling call options: From the graph we can easily interpret, that with a vertical call debit spread, we want the price to be at or above the original market price price. The strategy is also called the bull call spread, as "bull" implies our directional assumption about the trade.
Profit: The maximum profit we can obtain from this trade is equivalent to the difference between the ITM and OTM prices, we bought or sold a call at (respectively) and the premium. In the above graph, we can tell that the trader bought an ITM call @ $40.00 and sold an OTM call @ $45.00. Because options contracts are linked to 100 units of stock, the difference between these two prices is $5.00 x 100= $500. The premium, or $200, is subtracted from this difference to calculate the maximum profit of $300. Loss: Unlike the sale of a naked call option, the vertical call spread has a maximum loss of the amount paid for the premium of buying the ITM call. In past entries, I've alluded to the concept of naked options, or options sold by themselves. Option connoisseurs avoid selling novice options because of the risk. Although selling options has a better chance of being a winner than buying options, it has a capped maximum and an unlimited loss. Options traders are not to keen in assuming this risk and turn to various strategies in an effort to align their appeal for risk with their assumptions of the market's direction (bullish vs. bearish).
In the next few posts, we will be discussing vertical spreads. When creating a vertical spread, an option is bought or sold at prices above and below the strike price. We will be exploring:
While the terms 'debit', 'credit', 'long', 'short' etc might sound confusion, an easy way to remember is:
By selling a call option, the seller sells the right to the buyer to purchase the unit of stock from him/her at the set strike price, when the market value of the stock is less than the strike price at or before expiration. The seller sells the option with the assumption that the stock's price will move up or stay the same. In these cases, the seller will profit from the premium he/she has collected.
The probability of success with options is determined by the movement of the stock. For buying calls, if the stock's price...
Oh, no-- now we have to sell options? If you've understood the mechanics of buying options, you're already halfway there in comprehending the selling of options. All that's left is to reverse your role as from a buyer to a seller.
Just as stated before, the key elements to options transactions remain constant: the strike price, expiration, and option's premium. By selling a call option, the seller sells the right to the buyer to purchase the unit of stock from him/her at the set strike price, when the market value of the stock is greater than the strike price at or before expiration. The seller sells the option price with the assumption that the stock's price will move down or stay the same. In this case, the seller will profit from the premium he/she has collected. The probability of success with options is determined by the movement of the stock. For buying calls, if the stock's price...
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NishaNinteen year-old trader, future connoisseur of options. Follow me on Twitter!
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