The vertical spread option strategy is one of the safest and most consistently profitable strategies that any options trader can apply. In its various forms, it is ideally suited for all levels of options trading. In essence, selling vertical spreads (credit spreads) is a useful and relatively easy strategy for generating a steady, low-risk income or portfolio growth, and buying vertical spreads (debit spreads) is a cost efficient, lower risk strategy for buying calls or puts. Whether you trade debit spreads or credit spreads, you need to have first thought out the best strategy that applies to the trade.
A debit call spread is executed by buying an at-the-money (ATM) call option for while simultaneously selling a higher striking out-of-the-money (OTM) call of the same underlying security and the same expiration month. A debit put spread is similar, except buying an ATM put and selling an OTM put. This strategy is similar to that of buying calls or puts, but the advantages of this trade are:
- the cost of the trade is reduced by selling a call or put, and so the capital risk is lower.
- if the trade goes wrong, the loss is much less than that which would have occurred if you had simply bought a call or put.
The best strategy for a debit spread is the same one that you use for buying calls or puts. Swing trading focuses on trades that last 2-10 days, with fairly quick turnover. This is profitable with stocks, but with options, the profit potential is much greater. Because of the quick turnover, the risk of time decay on the cost of the options is much less. The disadvantage of this strategy is that you need to be fairly proficient in the technical analysis process that you need for swing trading, either with stocks or options, and this strategy is therefore not suitable for newer traders.
A credit spread is more dependent on longer term trends in the market than it is on short term swings, as would be the case with debit spreads. So, if you feel that the market, or your chosen stock, is going to go down, you would sell a bear call spread, which involves buying an OTM call option, and selling another call option that is closer to the strike price. If the stock does indeed go down, then both options expire worthless, and you get to keep your premium. If you felt that the stock is in an uptrend, you would sell a bull put spread, which means that you would buy an OTM Put option, and sell another put option that is closer to the strike price. The premium that you gain is yours to keep, and if the trend holds, you pocket the profit. The advantages of the strategy are:
- you gain your profit up front, and merely need to watch that the trend of your stock holds until expiration;
- technical analysis is fairly simple – you need to know how to identify a trend, and its strength, and to be able to find support and resistance levels. Several websites provide this information for free, so the strategy is particularly suitable for beginners.
- executed with a good trading plan, this strategy can result in a regular 8-12% growth in your portfolio every month.