Vertical Spreads

Description

If you plan to stick around for an extended period of time as an options trader then you had better learn how to become a spreader. You received an important taste of that in Module #2 with straddles and strangles. The next major category to learn about is basic vertical spreading. When you buy an individual option your potential upside for a call is unlimited and for a put, while it is not unlimited since the underlying cannot go below zero, it is a very large number. The downside of long options is that you own a wasting asset. When you sell an option then you reap the benefits of the erosion of time value in the premium of that option. You are giving somebody else the leverage that options possess in return for that benefit. The downside of short options is the unlimited risk associated with them.

In a basic debit or credit spread you buy and sell the same number of options, all calls or all puts, in the same expiration cycle at different strike prices. This substantially cuts down your risk should you be wrong even though it does limit your profits should the position move in your favor by a large margin. It is much more likely to hit singles and doubles than to hit a homer. Having been involved in options trading for over thirty-five years I can attest to the fact that traders who swing for the fences don’t last very long.

Beginning retail traders frequently believe, and are led to believe, that credit spreads are superior to debit spreads. You’ll learn that that is not true.