Creating a Risk Free Vertical Spread
Options are flexible tools. Once we understand how they work, we can modify basic strategies to optimize performance in pursuit of our objectives. In general, I am not a fan of vertical spreads - I much prefer without the protective wing and manage the trade itself via stops, rolls, or assignment protocols. That being said, there are instances where verticals are a useful tool in my toolkit.
Here's a more in depth video review for those interested: https://youtu.be/TaU62Y7u8Zw
Let's use a current trade in Netflix as an example:
The outline below will reference the chart above:
On 20Jan, after market close, Netflix (NFLX) reported earnings that didn't sit well with the market. They beat EPS expectations but sluggish sales forecasts (slower than expected subscriber growth) led to a nasty drop. #1 above
NFLX closed at $508.25 and opened after earnings at $400.43 before hitting a low of $379.99 the day after earnings and a cycle low of $351.46.
21Jan with NFLX trading ~ $390 I entered in the long calls. I felt the move was overdone and was bullish in NFLX long-term. I started with a very small initial outlay fully expecting additional downside movement in the short term. #2 above >BTO (7) 20May 550C @ 3.84
31Jan I slowly scaled in adding additional long calls following the upward movement. #3 above >BTO (3) 20May 550C @ 5.85
On 1Feb, after NFLX rallied from a low of $351 to a high of $458 - a 107 point move, I entered a short call position to turn the Long Call into a risk free credit spread. #4 above >STO (10) the 20May 570C @ 7.00
T1: BTO (7) 20May 550C @ 3.84 >$2,688 debit
T2: BTO (3) 20May 550C @ 5.85 >$1,755 debit
Note: Position basis = $4.44 per lot >Total Debit = $4,443
T3: STO (10) 20May 570C @ 7.00 >$7,000 credit
Note: I now have a +$2,557 net credit. The long call cost has been completely covered - thus removing the downside risk.
This is the initial PnL graph with T1 and T2 established - typical long call profile. We have risk to the downside, anything below our strike. We show an unrealized PnL currently (purple line) due to time value remaining in the long calls.
This is the PnL graph with T1, T2, and T3 established. Notice an important shift, the "max loss" is now ABOVE the 0 line. This means the trade has a locked in profit and regardless of where NFLX moves, profit will be realized.
Risk Free Vertical Outline:
This trade occurs from an important function - legging into the short after we experience a move in our favor. By waiting until we have an unrealized profit to establish the short leg, we can lock in a guaranteed profit will offering additional upside potential (than if we entered the vertical at the same time).
The downside, is we obviously need to accept the risk of the long leg
To establish the trade (can be call or put side):
We need to open the long leg and wait for a move in our favor
The longer we wait, the higher our minimum profit and the maximum profit will be. The trade off is we remain exposed via the long single option - there are no free lunches.
Once we have an adequate move (this will vary based on your strategy) we establish the short leg.
The width of the spread will determine our max profit potential
We need the credit received to offset the cost to enter the long side. In the example above, the long cost $4.65 after scaling in. The short collected $7.
$7>$4.65 thus we've removed downside risk and locked in a minimum profit
Important. Be mindful of expiration selection. If there's a significant move against the position or in favor of the position, we may need to wait for time to decay to realize max profit. Having both expirations in the same cycle simplifies this process. You can conceivable use shorter DTE short options however you will sacrifice upside potential (you won't be able to go as far from your long strike) and will collect a lower amount up front.
I originally learned this strategy from Lawrence McMillian in one of his books and revitalized the strategy when I connected w/ Chris during one of my Money Talks segments. This is a preferred approach for me when trading long options because it allows us to lock in a profit without scaling out of the trade (allowing for more upside potential).