Dr. Scott Brown Stock Options

Introduction There are many strategies that involve the use of two or more options at the same time & the Vertical Spread is one of those strategies. There are many “spread” strategies you can use with options. All spreads have one thing in common: They always involve the purchase of one option and the simultaneous sale of another of the same type (call or put). Basic types of Spreads: Vertical Spread – when you buy or sell different strikes within the same expiration month. Horizontal Spread – when you buy or sell the same strike but with different expiration dates.

Vertical Bull Spread All spreads are constructed by using all call or all puts. In other words, if you buy a call you must sell a call. Whichever strikes you choose for the spread, the options are always bought and sold in a 1:1 ratio which means you are selling one option for every option you buy. Notation: If you buy the $50 call and sell the $55 call it is called a $50/$55 vertical spread. This is considered a “long” position because you bought the more valuable option (lower strike call) and that means the money must be spent to buy the spread. Also called “debit” spreads. Profit / Loss Profile: Limited Risk & Limited Reward.

Max Gain, Max Loss & Break even Max Loss: As with any long position, the amount paid for the position. Max Gain: Maximum Value of the spread minus the amount paid for the position. Example: $50/$55 Spread (Bought $50 Call for $3, Sold $55 Call for $1). The most this spread could ever be worth is $5. This is because you paid a net $2 hence the most you could ever make is $3. Breakeven: When the spread is worth what you paid for.

Vertical Spreads Using Puts Suppose you buy the $50 put for $1 and sell the $55 put for $4. The gain / loss profile for a vertical put spread is very similar to the vertical spread using calls. However, the way each spread generates the same profile is different. Buying the $50 put and selling the $55 put is therefore a short $50/$55 vertical bull spread. Because both vertical spreads provide the same benefit/risk, traders will choose one over the other due to slight pricing variations. The important point is that buying the vertical call spread is identical to selling the vertical put spread.

Vertical Bear Spread Created by purchasing an option and selling another at a lower strike (Applies to both calls and puts). For example: Short $50 call / Long $55 call The trader needs the stock price to fall in order to make money on the spread. Hence the position is bearish.

Rationale for Spreads If you buy a vertical spread, you always buy the more valuable option. The sale of the reduces the cost of the long option. If you sell a vertical spread, you are selling the more valuable option. Selling an option by itself (naked) entails a lot of risk. With vertical spreads, you can hedge your risk by defining the maximum loss.

Cheap or Chicken The goal of the debit spread trader is purchasing the more valuable option. With the spread, the trader can reduce the premium paid for this long position. The goal of credit spread trader is to sell the more valuable strike and receive a premium. A valuable & humorous way of understanding the philosophies between credit and debit spreads: The debit trader is “cheap” since he or she doesn’t want to pay much for the long call position by itself. The credit trader is a “chicken” because in selling the more valuable strike he or she is fearful of the unlimited risk.

Early Assignment Traders new to vertical spreads are often concerned they may get assigned early on the short position. There are various actions that can be performed if your short position is assigned early to ensure you lock in the full benefit of the spread. Early assignment will therefore never hurt you in a vertical spread.

Vertical Spread Example Assume you are bullish on Google and wish to buy the $250 call but find that it’s trading for $80.40 and decide that is too much to spend. Instead of passing the opportunity, you decide to use a vertical call spread to reduce the cost of the $250 call. This is the cheap version of the vertical call spread; you are selling another option to reduce the cost of the long position. If you buy the $250 call and sell the $260 call, then you are long the $250/$260 vertical call spread.

Vertical Spread Example (Cont.) You can enter you order in one of two ways (depending on the broker): 1. Buy Google Jan. $250/$260 vertical call spread at market. 2. Buy Google Jan. $250 call and simultaneously sell the Google Jan. $260 call at market. $250 Call ask price: $80.40 $260 Call bid price: $73.20 When the order is placed: You will pay $80.40 and receive $73.20, a net debit of $7.20

Vertical Spread Example (Cont.) Once the order is filled, you are long the $250 call and short the $260 call. You have the right to buy shares for $250 and the obligation to sell them for $260, which means the most you could make is $10 on the spread. Because you paid $7.20 for the spread, the maximum profit is $10 - $7.20 = $2.80. Breakeven point is the net debit added to the $250 strike, or $250 + $7.20 = $

Vertical Spread Example (Cont.)

Risk and Reward Revisited Many traders find this to be a terrible risk-reward ratio. They reason that it doesn’t make sense to put $7 at risk in exchange for a $3 maximum profit. What they fail to see is that it has a higher probability of getting the maximum profit, than losing the $7. Don’t get trapped in believing that the spreads with the highest rewards and the lowest downside are superior. They are simply riskier and it is up to you to decide which sets of risks and rewards to take.

Price Behavior of Vertical Spreads Vertical spreads converge to a specific value as expiration nears. To understand the value one must think back to the mechanics of long calls and puts. As expiration nears, all in-the-money options converge to intrinsic value. As expiration nears, all out-of-the-money options converge to zero. Hence, vertical spreads converge to either intrinsic value or zero. The important point to understand is that vertical spreads do not respond quickly to changes in the stock’s price.

Price Behavior of Vertical Spreads (Cont.) This is because a vertical spread consists of a long and short option: As the stock price moves in any direction, one option increases in value while the other loses value. Net change to the vertical spread is small. Benefit of vertical spreads - allows investors and traders to enter into option positions cheaply Drawback of vertical spreads – highprofit will not occur unless a very favorable price change has occurred relative to time remaining on the option.

How Much Time? One of the 1st questions asked by investors regarding spreads is how much time to buy or sell. As with any strategy, each set of strikes and time frames creates a unique set of risks and rewards. If both strikes are in-the-money then shorter time frames provide a better chance for the spread to expire with intrinsic value. If you are buying out-of-the-money strikes then buying longer time frames will give you a better chance for the strikes to expire in-the-money. Providing a better chance for intrinsic value means less risk (which means less reward). The trick is to balance the risk and reward to suit your tastes.

Key Concepts Vertical Spreads have limited risk and limited reward. Vertical Spreads have a bullish or bearish bias. Vertical Spreads allow investors to buy long options for less money (debit spreads) and sell for less risk (credit spreads). Buying the call spread = selling the put spread. The higher the reward, the riskier the position. Spread values tend to move slowly. If you wish to collect the full value of the spread you must wait until very close to expiration.

Conclusion Vertical spreads allow you to profit on outlooks covering specific ranges of stock prices. Option trading goes far beyond the purchase of a call or put to capitalize on a directional outlook. The main purpose of this chapter is to allow you a glimpse into the world of higher level option trading. Options create opportunities that cannot be found with stock or any other assets.

Disclaimer DISCLAIMER: THE DATA CONTAINED HEREIN IS BELIEVED TO BE RELIABLE BUT CANNOT BE GUARANTEED AS TO RELIABILITY, ACCURACY, OR COMPLETENESS; AND, AS SUCH ARE SUBJECT TO CHANGE WITHOUT NOTICE. WE WILL NOT BE RESPONSIBLE FOR ANYTHING, WHICH MAY RESULT FROM RELIANCE ON THIS DATA OR THE OPINIONS EXPRESSED HERE IN. DISCLOSURE OF RISK: THE RISK OF LOSS IN TRADING FUTURES, FOREX AND OPTIONS CAN BE SUBSTANTIAL; THEREFORE, ONLY GENUINE RISK FUNDS SHOULD BE USED. FUTURES, FOREX AND OPTIONS MAY NOT BE SUITABLE INVESTMENTS FOR ALL INDIVIDUALS, AND INDIVIDUALS SHOULD CAREFULLY CONSIDER THEIR FINANCIAL CONDITION IN DECIDING WHETHER TO TRADE. OPTION TRADERS SHOULD BE AWARE THAT THE EXERCISE OF A LONG OPTION WOULD RESULT IN A FUTURES OR FOREX POSITION.HYPOTHETICAL PERFORMANCE RESULTS HAVE MANY INHERENT LIMITATIONS, SOME OF WHICH ARE DESCRIBED BELOW. NO REPRESENTATION IS BEING MADE THAT ANY ACCOUNT WILL, OR IS LIKELY TO, ACHIEVE PROFITS OR LOSSES SIMILAR TO THOSE SHOWN. IN FACT, THERE ARE FREQUENTLY SHARP DIFFERENCES BETWEEN HYPOTHETICAL PERFORMANCE RESULTS AND THE ACTUAL RESULTS SUBSEQUENTLY ACHIEVED BY ANY PARTICULAR TRADING PROGRAM. ONE OF THE LIMITATIONS OF HYPOTHETICAL PERFORMANCE RESULTS IS THAT THEY ARE GENERALLY PREPARED WITH THE BENEFIT OF HINDSIGHT. IN ADDITION, HYPOTHETICAL TRADING DOES NOT INVOLVE FINANCIAL RISK, AND NO HYPOTHETICAL TRADING RECORD CAN COMPLETELY ACCOUNT FOR THE IMPACT OF FINANCIAL RISK IN ACTUAL TRADING. FOR EXAMPLE, THE ABILITY TO WITHSTAND LOSSES OR TO ADHERE TO A PARTICULAR TRADING PROGRAM, IN SPITE OF TRADING LOSSES, ARE MATERIAL POINTS WHICH CAN ALSO ADVERSELY AFFECT ACTUAL TRADING RESULTS. THERE ARE NUMEROUS OTHER FACTORS RELATED TO THE MARKETS, IN GENERAL, OR TO THE IMPLEMENTATION OF ANY SPECIFIC TRADING PROGRAM WHICH CANNOT BE FULLY ACCOUNTED FOR IN THE PREPARATION OF HYPOTHETICAL PERFORMANCE RESULTS AND ALL OF WHICH CAN ADVERSELY AFFECT ACTUAL TRADING RESULTS. PS. In our opinion, we believe, it may be possible, that heavy smoking and drinking may be hazardous to your health. If you choose to smoke and drink while trading, The Delano Max Wealth Institute nor Dr. Scott Brown is liable for any damage it may cause. If you slip and fall on the ice, we're not liable for that either.