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Verticals Options Hawk

VIEWS: 3 PAGES: 5

									                                                    VERTICALS
Essentials

Long Call (Bull) Vertical
Long 1 XYZ Sep 50 call @ $2.00, Short 1 XYZ Sep 60 call @ $.75
Total Cost               Option premium paid, $125
Maximum Loss             Option premium paid, $125
Maximum Profit           Dollar value of difference between the strike prices minus premium paid, $875



Short Call (Bear) Vertical
Short 1 XYZ Sep 50 call @ $2.00, Long 1 XYZ Sep 60 call @ $.75
Total Credit Received    Net option premium received, $125
Maximum Loss             Dollar value of difference between the strike prices minus credit received, $875
Maximum Profit           Net option premium received, $125



Long Put (Bear) Vertical
Long 1 XYZ Sep 40 put @ $1.00, Short 1 XYZ Sep 35 put @ $.25
Total Cost               Option premium paid, $75
Maximum Loss             Option premium paid, $75
Maximum Profit           Dollar value of difference between the strike prices minus premium paid, $425



Short Put (Bull) Vertical
Short 1 XYZ Sep 40 put @ $1.00, Long 1 XYZ Sep 35 put @ $.25
Total Credit Received    Net option premium received, $75
Maximum Loss             Dollar value of difference between the strike prices minus credit received, $425
Maximum Profit           Net option premium received, $75




Explanation and Application

Verticals are the most basic option spread. You're hedging one option with another: when one makes
money, the other loses money. The idea is that in exchange for relatively low risk, you're giving up the
possibility of stratospheric gains. But don't scoff. Verticals (either a bull vertical or bear vertical) are
popular with professionals because of their limited risk nature and their profit potential that, though
limited, can still amount to many times the risk taken. In many stocks, option volatility and margin
requirements are so high as to prohibit either buying or selling options outright, whereas verticals typically
don't have such high cost or prohibitive margin requirements. Verticals can offer investors an efficient way
of creating long or short exposure in a stock.

Before we proceed, understand that a bull vertical is always long a lower strike option and short a higher
strike option, and can be either a long call vertical or a short put vertical. Conversely, a bear vertical is
always short a lower strike option and long a higher strike option, and can be either a long put vertical or
a short call vertical.

It's not enough to know a bull vertical spread is used when you are bullish and a bear vertical spread
when you are bearish. Should you be considering a vertical that's in-the-money (ITM), at-the-money
(ATM), or out-of-the money (OTM)? With respect to the stock's current price, a vertical might have one
option ITM and one OTM making it an ATM vertical. Therefore, an ITM vertical is one where both options
are currently ITM, and an OTM vertical is one where both options are currently OTM. Do you want the
passage of time to help you, or are you willing to let it hurt you? Do you think implied volatility will rise,
fall, or stay the same during your time frame? Verticals can be created to meet these requirements.

Verticals are named by their two strikes, with the lower strike first. So, if you buy the XYZ Dec 90 call and
sell the XYZ Dec 115 call, you bought the XYZ Dec 90/115 call vertical. Incidentally, this is known as a 25
'point' vertical, because the difference between the strike prices is 25 points.

At the expiration of the options, a vertical will always have a value between $0 (when totally OTM) and
the difference between the strikes (when totally ITM). For example, if the stock price is $120 at
expiration, the 90/115 call vertical will have a value of $25 (115 - 90), while the 110/115 put vertical will
have a value of $0. A bull vertical maximizes its value when the stock price is above the higher strike price
at the expiration of the options. A bear vertical maximizes its value when the stock price is below the
lower strike price at the expiration of the options.

Let's assume that you believe a stock will rise in value, and you want to use the limited risk and limited
reward characteristics of a long call vertical to profit from the rise. It's natural to consider one that can
earn a lot more money than it can lose. For example, paying $1.00 for a long OTM XYZ Dec 130/140 call
vertical that has the chance to go to $10.00 (10 point vertical).

That's a 'risk 1 to make 9' scenario. But that might require a significant rally in the stock price, and
depending on the expiration date of the option, a move of sufficient magnitude may not be very likely.
You have to be aware of the fact that until the rise in the stock price happens, time is working against the
long OTM vertical's value. Also, a decline of implied volatility would decrease each of the OTM verticals'
values.

You might be able to buy a long ATM XYZ Dec 110/120 call vertical for about $5.00 (10 point vertical),
which would be a 'risk $5 to make $5' scenario. It is more likely that the stock price will rise enough for
the ATM call vertical to maximize its value than for the OTM call vertical to maximize its value. But your
risk is higher ($5 versus $1) and your potential profit is less than for the ATM call vertical ($5 versus $9).

You could buy a long ITM XYZ Dec 90/100 call vertical for $8.00 with the price of XYZ at $110. Not many
beginning option traders would consider paying $8.00 for a 10 point spread. That's a 'risk $8 to make $2'
scenario. But let's think about it in terms of the likelihood of the stock price being greater than the higher
of the two strike prices (100) of the vertical at expiration. If the stock rallies to $112, the stock price will
be greater than the higher strike price, and the long ITM call vertical will profit. If the stock price sits still
at $110, the long ITM call vertical will profit again. Even if the stock falls to $105 but stays above the
higher of the two strikes in the call vertical, it still profits. Of course, if the stock price falls too far, for
example to $90, you'll lose more money on the long ITM call vertical than you would on a long ATM or
OTM call vertical ($8 versus $5 or $1). It is more likely that the long ITM call vertical will reach its
maximum value, but the risk is higher and profit potential lower than either the ATM or OTM call verticals
($2 versus $5 or $9). The passage of time and changes in implied volatility have the opposite effects on a
long ITM call vertical than on a long OTM call vertical.

Your first thought is that you might just as well buy a further dated vertical because you have more time
for the stock price to rise. That is a reasonable assumption, but more time to expiration means that your
call vertical will not rise or, for that matter, fall in price as fast as a vertical that's closer to expiration.
That's because the gamma for verticals with more time to expiration is smaller than the gamma for
verticals that are closer to expiration.

Another reason for trading verticals is to exit a position in one option and enter into another (called
"rolling" risk up or down). For example, if you are long 1 XYZ Dec 50 put, and you wish to sell that put
and buy 1 XYZ Dec 40 put, you could sell 1 XYZ Dec 40/50 put vertical in one trade instead of doing two
separate trades. When the short 1 XYZ Dec 40/50 put vertical is combined with the original position of
long 1 XYZ Dec 50 put, the resulting position is long 1 XYZ Dec 40 put. The vertical allows you to
restructure your option position more efficiently and with less cost (1 ticket charge versus 2 and,
hopefully, a narrower bid/ask spread on the vertical versus two bid/ask spreads on the naked options).

Like a lot of people, you might be long stock. But reading this article got you thinking about trying
verticals. Rather than selling your stock and buying a vertical, you can sell a call and buy a put, creating
what is commonly known as a "fence", but which is basically the same as a vertical. Now you'll see why
it's good to understand "synthetics".

If you want to turn long XYZ stock into a bull vertical, buy a put with a lower strike and sell a call with a
higher strike. For example, buy the XYZ Dec 100 put and sell the XYZ Dec 120 call. The long XYZ stock
and long XYZ Dec 100 put are a synthetic long XYZ Dec 100 call. Add that to the short XYZ Dec 120 call,
and it mimics a long XYZ Dec 100/120 call vertical.

If you want to turn long XYZ stock into a bear vertical, buy a put with a higher strike and sell a call with a
lower strike. For example, buy the XYZ Dec 120 put and sell the XYZ Dec 100 call. The long XYZ stock and
short XYZ Dec 100 call are a synthetic short XYZ Dec 100 put. Add that to the long XYZ Dec 120 put, and
it mimics a long XYZ Dec 100/120 put vertical.

Traditionally, brokers have sold fences as a strategy to limit the risk of the long stock with the long put,
and then offset the cost of the put by selling a call. Now you know that they are creating verticals. You
can even see how your position is doing by monitoring the price of the vertical.



Greeks

The key to understanding the greeks of a vertical is to know where the stock price is in relation to the
strike prices. When the stock price is at or close to one of the strike prices, the gamma, theta, and vega
are highest for that strike and will dominate the gamma, theta, and vega for the other strike. Investing a
little time simulating verticals on the Analysis Page can help you learn the nuances of the greeks of
verticals much better than we can possibly write. So use the tools we provide you and zoom up the
learning curve.

The delta of a bull vertical is never negative, and the delta of a bear vertical is never positive. But how
positive or how negative the vertical's delta is depends mainly on the where the stock price is relative to
the strike prices of the vertical and how far apart the strike prices are from each other. For example, if the
strikes of the vertical are relatively close to one another (at adjacent strikes, or one or two strikes away),
the relative difference between the deltas of each option can be small, especially if the vertical is OTM or
ITM. So, the vertical has a relatively small delta. But if the strike prices are far apart, the relative
difference of deltas of each option can be large, and the delta of the vertical will be large also. Add in the
skew of implied volatilities for each strike and time to expiration, and the delta of verticals can be a richer
tapestry than anything found in The Cloisters.

The delta of a call bull vertical is the same as the delta of the put bull vertical at the same strikes. To see
why, remember that the sum of the absolute values (add them together as if they were both positive) of
the call and put at the same strike and expiration is roughly equal to 1.00 (depending on the theoretical
model used). If the delta of the long lower strike call is +.90, the delta of the long lower strike put is
approximately -.10. If the delta of the short higher strike call is -.85, the delta of the short higher strike
put is approximately .15. Therefore, the delta of the long call vertical (+.90 - .85 = +.05) is equal to the
delta of the short put vertical (+.15 - .10 = +.05).

Just as when time passes and the deltas of individual options move closer to 0.0 (if OTM options) or 1.00
(if ITM options), so too do the deltas of verticals. For an OTM vertical, the deltas of both options are
moving towards 0.0, for an ITM vertical, the deltas of both options are moving towards 1.00. Therefore,
all other things being equal, the delta of both the OTM and ITM vertical is moving towards 0.0. But where
one option is ITM and the other option is OTM, all other things being equal, the delta of the vertical moves
towards 1.00. The delta of the ITM option is moving towards 1.00, and the delta of the OTM option is
moving towards 0.0. That's why you have to watch these verticals very closely as they approach
expiration. They begin to act more and more like a stock position as their delta gets closer to 1.00.

The gamma of a vertical tends to be pretty tame. Sure, it can switch from positive to negative, depending
on where the stock price is in relation to the two strike prices of the vertical. But that's about it. The
reason why the gamma can switch from positive to negative is easy. When the stock price is close to the
strike of the long option, the gamma of that option is bigger than the gamma of the option at the short
strike. The gamma of the vertical is positive, and you want the stock to move. When the stock price is
close to the strike of the short option, the opposite is true. The gamma of the vertical is then negative,
and you want the stock to sit still. Easy, isn't it?

The gammas of a long call vertical and a short put vertical at the same strikes are the same, because the
gammas for calls and puts at the same strike are nearly equal. Just subtract the gamma of the short strike
option from the gamma of the long strike option and you'll see they have nearly equal gamma.

All other things being equal, an increase in volatility decreases the value of ITM verticals and increases the
value of OTM verticals. This is because of the increased likelihood the ITM vertical will not stay ITM, and
the OTM vertical could become ITM. All other things being equal, time passing increases the value of ITM
verticals and decreases the value of OTM verticals. With less time, there is less of a chance the stock price
will move enough to hurt an ITM vertical or help an OTM vertical. The vega and theta of verticals indicate
this and depend on where the stock price is relative to the strike prices and how far apart the strike prices
are from each other. So, considering the long ITM call vertical and short OTM put vertical at the same
strikes, each has negative vega and positive theta. A long OTM call vertical and a short ITM put vertical
have positive vega and negative theta. You can get the vega and theta exposure you want by selecting
which strikes you buy and sell.

Ultimately, it's very important that you take into account all the factors that influence a vertical's value.
Inexperienced traders often only look at delta exposure, and forget to consider their position's vega and
theta. Testing a position on the thinkorswim Analysis Page before you do a trade can let you see the
effects of changes in the stock price, volatility, and time. It's better to do your homework than be
surprised by the unexpected.



Structure

A vertical has options at two strikes in the same expiration month on the same stock. The options are
either both calls or both puts, with one long and the other short. A long call vertical is long a lower strike
call and short a higher strike call. A short call vertical is short a lower strike call and long a higher strike
call. A long put vertical is long a higher strike put and short a lower strike put. A short put vertical is short
a higher strike put and long a lower strike put.

Other sources may describe these as "bull" or "bear" credit or debit spreads. That's not incorrect, but it
doesn't really explain what's going on. Yes, a long call vertical gives you the same exposure as a short put
vertical, but the former is a debit spread and the latter is a credit spread. Is that a significant difference?

The relationship between a call vertical and a put vertical at the same strike prices and in the same month
is the box spread. The box spread is basically a delta-neutral option position that act's something like a
zero-coupon bond. Movement in the stock price doesn't really change the value of the box that much. A
long box is made up of a long call vertical and a long put vertical at the same strikes. A short box is made
up of a short call vertical and a short put vertical at the same strikes. If your position is a long call vertical
(a bull vertical), and you overlay a short box, the resulting position will be a short put vertical (also a bull
vertical). If your position is a long put vertical (a bear vertical), and you overlay a short box, the resulting
position will be a short call vertical (also a bear vertical).

One way to capitalize on this knowledge is when holding a vertical that is deeply ITM. This may have
occurred after a big move in the stock, which has turned your OTM or ATM vertical into an ITM vertical.
Typically, ITM options and verticals have wider bid/ask spreads (because their component options each
have a high delta) than OTM verticals. So, rather than taking profits by liquidating an ITM vertical, you
could buy the low priced corresponding OTM vertical which should ordinarily have a narrowly quoted
market. The result of this trade is to lock in your profit by establishing a box spread. Be aware, though,
that the box spread might require later transactions, exercises/assignments or allowing usually two and at
least one of the options to expire worthless. If the bid/ask spread on the OTM vertical is sufficiently less
than the bid/ask spread on the ITM vertical, it would result in savings that exceed the commissions on the
box spread. A box spread has pin risk so make sure you are on top of it at expiration.



Pricing

First, understand that a long box spread (a delta neutral interest rate position) is comprised of a long call
(bull) vertical and a long put (bear) vertical at the same strikes. Because we can calculate the fair value of
the box all by itself, using simple algebra we can calculate the value of the call vertical from the value of
the box and the put vertical, and vice versa. If the box XYZ Dec 100/105 box is worth $4.95, and the XYZ
Dec 100/105 call vertical is worth $3.50, the XYZ Dec 100/105 put vertical must be worth $1.45. Because
of the box spread, if the call vertical goes up, the put vertical must go down.

								
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