Hedging with Vertical Spread in uncertain times

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A vertical spread is a common options trading strategy that involves buying and selling options of the same type (either both CALL options or both PUT options) on the same stock with the same expiration date, but at different strike prices. It gets its name from the way the options are arranged on a graph, with the strike prices on the vertical axis. i.e. one option on top, one option below. Using a vertical spread can help us control risk.

There are 4 common vertical spreads, which can be divided into 2 camps. The debit (buy) camp and the credit (sell) camp. The main difference between this 2 camps is that the debit camp pays money for the spread, whereas the credit camp gets money for the spread. In the debit camp, we have the Debit CALL Spread (a.k.a Bull CALL Spread) and Debit PUT Spread (a.k.a Bear PUT Spread). For the credit camp, we have the Credit CALL Spread (a.k.a Bear CALL Spread) and Credit PUT Spread (a.k.a Bull PUT Spread). Each of these camps control risk in a different manner.

Debit Camp (Buy camp) risk control
For the debit camp, doing a vertical spread instead of simply buying a single leg option helps with reducing the cost which helps to reduce potential losses. On top of that, using options instead of buying the stock outright helps to reduce potential losses too. However, the downside is that we are reducing our potential profit.

For example, if we were to buy 100 shares of ABC at a price of $10 each, we would have risk $1,000 upfront. If ABC were to go bankrupt due to recession, we will lose $1,000. However, had we bought a CALL option with a strike price of $10 instead, and we paid a premium of $100. If ABC were to go bankrupt due to recession, we will only lose $100.

If we bought the CALL option, we could further reduce our potential losses by turning it into a Debit CALL spread, by selling another CALL option. Thus, selling another CALL option with a strike price of $15 for $30, for example, we will reduce our total cost to $70, and thus lowering our max loss. However, the trade off is that our potential profit is now capped. If ABC rallied to $20 or $100, that is none of our business

So we can see how doing a debit vertical spread can help us reduce our risk exposure, which in this uncertain and volatile times, might be a good strategy.

Credit Camp (Sell camp) risk control
For the credit camp, doing a vertical spread instead of simply selling a single leg option helps with controlling potential huge losses. You can think of this as putting a "stop loss" on our options.

For example, if we were to sell a CALL option with a strike price of $10 for $100 in premium. The max profit we can earn is $100, but if the share price goes to $20 or $101 we would lose $900, $10,000, and so on. Thus, buying another CALL option with a strike price of $15, for example, will cap our max loss by giving up some of the premium we collected. This works the same with selling a PUT option.

This is especially important when the market is very volatile, like right now, the market could at any time crash real hard or rally real hard. For example, if US defaults, and the market crash by say 50%, those who sold PUT option instead of a Credit PUT spread will be taking a much greater losses. However, if the world suddenly became peaceful, and all the stocks rallied back to their all time high, then those who sold naked CALL option instead of a Credit CALL spread will suffer huge losses.

Conclusion
So in this short discussion, we have seen how vertical spread helps to reduce losses by giving up some of our profit. If you like to do a vertical spread, do make sure that you have updated Moo Moo app to version 13.16 and above. You should be able to select vertical spread in the options tab and trade it easily

If you like you can also join all the option chat group by searching option and selecting Groups. In the groups, we can ask questions and discuss about options This way, we all can learn together