Buying a long option is a great way to speculate on an expected increase or decline in a stock or ETF’s price but they also come with a couple of big disadvantages to account for when planning your trades.
First, long options have a time limit or expiration date. If the market doesn’t move in the direction of your forecast between the time you buy the option and expiration, you will lose your opportunity to profit.
The second disadvantage that faces long option buyers is the impact of time value. Even if the market moves the direction of your forecast, time value eats away at your profits and can turn a potential winner into a loser.
There is a partial solution to the second problem. You can reduce the impact that time value has on your long option trade by turning it into a long vertical spread. That means that you are still buying a long option but you are selling another, further out-of-the-money, option with the same expiration date against that long position.
The premium you receive from the option you sold helps to offset the decline in time value on the long option. Like short vertical spreads, a long vertical spread has a fixed amount of risk and a capped maximum gain.
Balancing the advantages and disadvantages as you evaluate spread opportunities starts with understanding how they related to each other and how to construct the trade. When done correctly, a vertical option can be a great way to make money in an uncertain market.
In the video above, I will walk through setting up a long put vertical-spread on the QQQQ. Assume in this case, that your attitude has become bearish on the market and you are expecting a drop in price and therefore a long put position looks good.
I will show you how to add a short put position (creating a long vertical put spread) against that long put to significantly reduce the cost of the trade and the impact of time value.
The trade off between reduced time value erosion in return for lower upside potential in a long vertical spread is a classic example of one of the truths in the options market. If you want lower risk you will get lower potential returns. Greater probability of a loss usually comes with higher potential gains.
Calculating the maximum risk in a long vertical spread compared to your maximum gain is relatively easy and can help you plan your trades. If the maximum gain in a particular trade is too low compared to the potential loss then the trade is probably not a good candidate.
With vertical spreads you have an advantage over an outright option position where you have very high costs but traders may be reluctant to give up on outright call or put positions because they have theoretically unlimited gains.
However, depending on what you are trading, the probability of very large moves in the underlying stock that would result in those big gains is very low. This is particularly true of ETFs. Realistically, giving up the “unlimited” gain potential of a long call or put is probably not a bad trade off at all.
Here is how you can easily calculate the maximum loss or gain potential of a long vertical spread:
Maximum gain: Take the difference between the two strike prices and subtract what you paid for the spread when you entered the position originally. In the video above I will run through this calculation on our example on the QQQQ. This is the most you can possibly gain – assuming that the stock rises the direction you forecasted.
Maximum loss: Like an outright long call or put position, your losses are limited to the amount you spent (the debit) to enter the trade in the first place.
In our example from the video above, I paid $.45 per share or $45 per contract to enter the long put spread. This was considerably lower than what it would have cost if I had just purchased the long put alone.