Thursday, 31 July 2008 10:56 Written by John Jagerson
Having already presented the drawbacks and advantages of vertical spreads in the last section of this lesson, we will take a much closer look at a live market example. In this case, I am going to use an ETF and its options for the trade. If you need some help understanding what an ETF is and why they are some of the best stocks available in the market - Click here. The ETF we will use is the iShares Russel 2000 index ETF or IWM. The reason I picked this is because it offers some of the key benefits we have to insist on before getting into an option spread. These benefits are as follows: tight bid/ask spreads, strong stock volume, available options and flexible strike prices.

Putting the trade together:
Option Spread
1.  In the video I will sell a put (because we are bullish on the stock) assuming that the put will expire worthless. That put I sold or "shorted" will turn into profits if prices rise and it either expires worthless or I buy it back to close the trade for a much lower price.

2.  Next I will cover the "unlimited" risk of the short put by buying a second put with the same expiration date but a LOWER strike price. That put will cost less than I was paid originally, and the difference is what creates the credit or maximum profit potential of the trade.

By constructing the spread like this we preserve the benefits of recieving a credit while simultaneously limiting the trade's risk. Once you have seen the video paper trade the same strategy on your own. Getting some experience without risking any money is critical to your ability to retain the information and begin using virtical spreads yourself.

Option traders typically work with more complex order types than stock traders. What questions do you struggle with when trying to understand how option trades are executed? Ask us in the forums.

 

 

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