vertical spread advice

I am interested in trading vertical spreads. I would appreciate your words of wisdom or advice for executing these trades successfully. A couple of specific points I have been pondering...

1. I have read not to open a spread which shows less than an 85% chance of expiring in the money. Do you agree with this statement?

2. What is a good return on risk for this type of trade?

3. When do you exit if the trade is moving against you?

Thanks

 

Vertical spreads are more frequently referred to as bull or bear spreads and as credit or debit spreads.

Specific points your pondering:
1) No, I would not agree. If your position is a credit spread you'd want both options to expire out-of-the-money. The following are for examples only and are not to be considered as investment advice. All prices are based on closing prices and are at the natural without commissions.

Occidental Petroleum (OXY) closed at 100.93
A bull credit spread with puts:
Buy to Open (BPO) 10 July 100 @ 2.03
Sell to Open (SPO) 10 July 97.50 @ 1.24
The credit on the spread is .79 , with the spread of 2.50 points the maintenance requirement is $2,500 on 10 contracts. With the credit of .79 x 10 equals a credit of $790 or a initial requirement (max loss) of $1,710. $790 divided by $1,710 = a 46.20% return IF all options expire worthless and you keep the credit. Breakeven point @ 99.21.

or

BPO 10 July 95 @ .72
SPO 10 July 97.50 @ 1.19
The credit is .47 or $470 divided by the initial req. (max loss) of $2,030 for a 23.15% return and a BE of 97.03.

As you can see the more you are out of the money the lower the return, but the more the underlying must move against you to be a problem. In these two examples, the underlying is above the short strike in both examples. If one was to take on a bull position with the underlying in-the-money the potential return would be higher but in that case the underlying must move higher for the options to expire.

A Bull debit spread with calls:
BCO 10 July 95 @ 6.75
SCO 10 July 100 @ 3.00
Debit = 3.75 or $3,750 (max loss) Here you would want both options to expire In-the-money for the full 5 point spread, or a 33.33% profit less commissions.

or

BCO 10 July 100 @ 3.05
SCO 10 July 105 @ .88
Debit 2.17 or $2,170, if both options are ITM at expiration for 5 points the return would be 130.41% . But the underlying must move higher.

You should see how to be bearish with puts or calls credit or debit.

All the examples above should answer your # 2. The Risk should always be justified by the Return. Just how bullish or bearish (or neutral) are you? It's best to enter the trades as a spread order to make sure you have both sides. Most of the time I do market orders. Some will say they get ripped on market orders, but most of the time the difference is less than a nickel, if a nickel is going to make or break the trade then you probably shouldn't be doing it in the first place.

As for #3. I've seen a lot of traders, and one thing seems common. I hear them say .. " I wish I was out of that.... If it will just get back to breakeven I'll get out" If you find your wishing you didn't have a position, then GET OUT of the position. In options one is reevaluating the position fairly often. I'm not saying you have to watch it tick for tick. How much time is remaining, are you In, or Out the money... is your position one that you MUST exit in order to avoid the additional cost of exercise and/or assignment. All play a factor in when or if you enter the exit order.

 

Thanks for your response stoic. Can we dig a little deeper?

I know that bull/bear spreads can be structured as either a credit or a debit. When does it make sense to structure your trade as a credit vs. a debit?

I am thinking it would be best to use a credit spread when IV is high relative to the historical volatility. This way you collect the premium due to the high IV. You should end up ahead if the IV reverts to the historical volatility. Conversely, a debit spread should be employed when the IV is lower than the historical volatility. Is this the correct logic?

Another question is when do most people enter the trades (i.e. How many days until expiration?) Obviously, the farther out you enter the trade, the more premium you will collect.

 

As for your first question, and as far as in ANY stock or option trade, long or short, spread, bull or bear, debit or credit, or the Short-Broken Wing-Calendar-Condor Spread (better known as the gobbily-goop spread or alligator spread) The bottom line is WHAT do YOU THINK the underlying is going to do, AND WHAT strategy do YOU THINK will best profit from that move based on YOUR tolerance for risk.

Your second question. Sounds good in theory. But if your looking at a debit spread and the In-the-money calls show a higher IV then the HV you'd be inclined to not do the trade, or the out-of has a lower IV vs. HV you'd be inclined not to do the credit spread. (see the attached)

Now! I'm sure I'm going to get a lot of flak for this, (won't be the first time) but in this forum you'll get a lot of gamma- scalping this and Theta that... Volatility Skew here and a smile there. It's all just a Theoretical model. In my 31 years of trading, I've worked with hundreds of Lic. Brokers, entered hundreds of thousands of orders for rich and active traders, and not once has anyone shown me a successful track record of option trading based on theory. IMO if more people spent as much time on analysis of the underlying as they do on theory, their overall profits would greatly improve.

As for "Time" ... for me ...if I'm looking at a credit spread, it will be pretty short term, in the credit spread "Time is your ally" I look to get the most of the accelerated time decay with the least amount of time in the market. Generally 30 days or less. As for a long or debit spread, I hate being right with too little time. I'd rather buy more time than I need than have the underlying make its move (if required) right after my options expire.

 

Thanks for your advice stoic. Do you think about volatility at all when entering new positions? I understand that having an idea of where the stock is likely to go from technical analysis is key. But shouldn't volatility also be part of the equation when contemplating a new position?