Vertical Spreads and Alice
In Lewis Carroll’s Alice in Wonderland, Alice asks; “Would you tell me, please, which way I ought to go from here? That depends a good deal on where you want to get to. I don’t much care where – Then it doesn’t matter which way you go.” Vertical spreads would agree with Alice, we don’t care much where the trade goes. Stocks will go up, down or sideways, up a little or down little. Of the five directions a stock may move, verticals will benefit the trader in 4 out of 5 of those possible directions. Like Alice, it doesn’t really matter where the stock goes.
Which is easier, picking where the stock will go or where it won’t go? The answer is where it won’t go; you will be right 4 out of 5 times. Most strategies face much harsher odds. Trying to pick where the stock will go will be correct only 1 out of 5 times. Verticals are much more forgiving. Let’s look at a hypothetical trade. XYZ stock is trading in a range between $100 and $110. The stock has run up to $110 resistance on low volume and seems to be turning over with a current value of $108. The trade will be to sell out of the money calls at $112 with another call bought at $113 as a hedge. The purpose of this trade is to have both options expire worthless. The $112 call is the reason for the trade, the $113 is for insurance against the unlikely event the stock changes direction, breaks resistance and moves above the $113 dollar value. Selling about 30 days before expiration will provide little time for the trade to achieve $112 value. If all goes according to plan, the trade will achieve success if the stock remains below the $112 value.
|Stock price at expiration||Success or Failure|
As you can see from the chart above, most scenarios will prove successful with only one situation where the trade would fail. This is considered a high probability trade. If the stock trades anywhere below $112, this vertical spread will be at max profit. As long as the trade stays in the $10 range between support and resistance the trade will be profitable. Like Alice’s comment “I don’t much care where,” verticals tend to work the same way. When setting up verticals, we pick the time frame, the situations where the stock price may go, and where the stock price may not go. Verticals have flexible rules, plenty of setups, and a lot of solutions.