Vertical Spread Newbie question once again

Discussion in 'Options' started by bearnbull, Jan 23, 2011.

  1. After reading some materials about credit vertical spreads, I notice that it was never mentioned that I can close my position once I hit the maximum profit before expiration. They always talk about maximum profit/loss and break even point. If I close the position when I'm well over my short before expiration' do I keep the credit?

  2. Sure you can close credit spreads (or debit spreads) at any time of course. Your wording isn't real clear as you don't state if you are talking about bull put spreads (I think you are) or bear call spreads. You mention "when I'm well over my short ..." so I think you mean when the stock has gone above your short in a bull put spread.

    Lets look at an example:
    If XYZ is 52 and you sell a 50 put for $200 and buy the 40 put for $50 (getting $150).

    Now, at any point you can rebuy the 50 put for $150 or less, you can make money (not including commissions of course)

    So, if after a while the stock was now $58 and the prices were (for example):
    50 put - $50
    40 put - $10.

    You could buy back the short 50 for $50 thus netting $100 and still own the 40 put, or you could buy back the 50 and sell the 40 for a total of $40, thus netting $110, but no longer having the 40 put of course (which is probably better as the stock is now at $58!) So, basically you keep your credit minus whatever you paid. If the stock went up enough (say $65), and the 50 put was only worth say $5, you could (And probably should IMO) spend the $5 to close the short side.

    Most books, training classes, etc. discuss P/L at expiration because it is hard to show specific numbers at other times due to time value, IV, etc.

    I hope this answers your question.

  3. It depends on the magnitude of the move the underlying has made in the desired direction and the amount time which has passed since you entered the credit spread. For example assume you sold an out of the money bull put spread on AAPL of 310/300 (i.e. sell the 310 put and buy the 300 put) for a credit of 1.20 when AAPL is trading at $325 on Jan 3rd. You could make money on this spread in a variety of ways but traditionally you would wait for AAPL to close above $310 on Friday expiration to collect the entire credit. Even if AAPL shoots up to 400 the next day (Jan 4) there is still going to be a slight debit (.02-.05) to buy back the spread so you would technically NOT collect the "max profit" value if you bought back your credit spread prior to expiration.

    Back in November I did a JAN 520/510 bull put on GOOG when they were hit hard with news of EU investigation of a web search monopoly plus talk of them acquiring Groupon for $6B. I received $2.30 for the bull put and despite GOOG's substantial climb since then (GOOG traded as high as 640) the bull put could never be bought back for .00 or even .05. Therefore it's next to impossible to collect "max profit" prior to expiration as there is still time value in those options unless you wait till expiration. However you could probably collect 95-97% of your entire credit prior to expiration PROVIDED the underlying makes a substantial enough move in your desired direction and/or enough time has passed.

    The credit you get to keep depends upon how much it costs to buy back the same spread you sold which effectively closes the trade. Going back to the AAPL example let's say AAPL has moved up from $325 to $350 in two weeks (Jan 17). To close the trade you must enter into the opposite of your bull put transaction which is a 300/310 bear put spread (i.e. buy the 310 put and sell the 300 put). In our example the 310/300 bull put spread went for a net credit of $1.20 but let's say the 300/310 bear put spread costs .15 cents. Therefore the profit on the trade would be:

    Initial Trade with AAPL @ $325 on Jan 3
    310/300 Bull Put: STO 310P - BTO 300P = $1.20 Credit

    Closing Trade with AAPL @ $350 on Jan 17
    310/300 Bear Put: BTC 310P - STC 300P = .15 Debit

    $1.20 (Bull put credit) - $.15 (bear put debit) = 1.05 (Profit).

    However in a different scenario let's assume AAPL is only trading at $330 on Jan 17 then the bear put spread is going to cost a lot more reducing our profit because the 310 put is more expensive to buy back. In this instance let's assume the debit for the bear put spread is going to be .40 cents. Therefore our profit would now be:

    Initial Trade with AAPL @ $325 on Jan 3
    310/300 Bull Put: STO 310P - BTO 300P = $1.20 Credit

    Closing Trade with AAPL @ $330 on Jan 17
    310/300 Bear Put: BTC 310P - STC 300P = .45 Debit

    $1.20 (Bull put credit) - $.45 (bear put debit) = .75 (Profit).

    As you can see the extent to which AAPL has moved up in the time since the credit spread was entered had a significant impact as to the profitability of the trade assuming you want to close it before expiration.

    However if you held onto the credit spread going into expiration with AAPL at $330 or $350 or even if it was at $310 you would still collect the full $2.30 as your "max profit" is reached at $310 if you hold onto the credit spread. That being said many a times you're better off buying back the spread prior to expiration if you've made 85-95% of the credit instead of waiting for that marginal 5% as there are instances where the stock can retrace causing you to possibly even take max loss.

    Remember that bulls make money, bears make money but pigs get slaughtered.

    Hope this helps! :)
  4. In order to achieve the maxiumum profit of a vertical spread, you're going to have to be very close to expiration or very far OTM, or some combination of both.

    To see this, get hold of some historical quotes and graph a spread in Excel or use an option program that will chart the position prior to expiration.
  5. Thanks for all the replies. Now I'm getting a better picture of the strategy. Time decay is a huge factor in this strategy to say the least. Option trading is more complicated than I thought--but I'm loving every bit of it.

    Cheers to all:)