One of the key benefits of trading options is that instead of a straight-line Profit & Loss curve that Futures offer, options can be customized to fit the reward and risk of a trader.
Over millions of options strategy combinations can be achieved from the options chain and one of them is vertical spread. The vertical spread family can consist of multiple strategies, but the most popular ones are Bull Call Spreads & Bear Put Spreads.
A bull call spread is a strategy where one buys a Call option and sells a higher strike call option. The net premium outflow reduces to the extent of sold options premium and yet the risk reduces as you have less to lose.
At the same time, the trade-off is that bull call spread offers a limited upside versus a simple long call. How much risk is one willing to take and how much reward one expects varies from trader to trader but in this article, we’ll learn that being an opportunist when should one prefer a bull call spread over a long call. Similarly, the concept could be applied for a Bear Put Spread versus a Long put.
Time
A key input for choosing an options strategy revolves around time. If the time frame for a forecast is extremely short term i.e. 3-4 days then in most cases Long call will be a preferred strategy but, the moment the forecast is for a long time period then getting compensated for the time with a vertical spread is a good idea.
Vertical spread can improve the pay-off in terms of reward to risk when the time frame is more positional (generally more than 4 days) and the strategy can also be carried till expiry.
Momentum
Consider a market which is oscillating within a few hundred points, it becomes a challenging task to identify stocks which may witness a directional move, in these cases, a lot of Theta is lost in expectations of breakouts which lacks due to the overall market structure.
In a market where momentum is lacking, vertical spreads can be a better bet versus buying a single option.
Expiry Placement
Expiry placement or days to expiry, is an important input when deciding on an options strategy and where are you placed in the expiry affects the decision. From mid expiry when the options theta starts to decay faster, it is generally a better idea to resort to vertical spread over single options contract.
Most importantly, in the expiry week when options are decaying very fast it might always be a good idea to resort to a vertical spread for any trades being carried for more than a day.
Risk Aversion
Many investors look forward at options to build their portfolio and to make returns from medium-term moves. Since deploying a vertical spread is far cheaper than trading futures, it naturally restricts the risk.
A vertical spread with one OTM as buy and few OTMs as sell strike typically offers a 3:1 reward to risk. It means that if you succeed you make 3 times more profit than the risk you take and for strategies with medium term approach, this helps in reducing risk yet providing a handsome profit potential.
Strategic Forecasts
In many cases traders do forecast probable targets of an underlying equity and trades for them. Vertical spreads are a good way to trade if you are confident that the target will act as a resistance.
If your forecast suggests that the underlying equity may not move above those levels, then in those cases you may not want to pay a high premium that a single option brings to the table. Instead, selling the strike of the target reduces your premium outflow and optimizes your trade to customize to your forecast.
Disclaimer: The views and investment tips expressed by the investment experts on Moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.
