Diving Into Vertical Spreads

Gun for profits when there are more than two weeks remaining.
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This column was originally published on RealMoney on June 2 at 5:13 p.m. EDT. It's being republished as a bonus for TheStreet.com readers.

Some of the most frequently asked questions I get concern vertical spreads, such as this from Krish:

In a bull call spread of $2.50, assuming the underlying stock price is rising, shouldn't the calls which you are long outperform the calls in which you are short, resulting in an unrealized profit that can be realized by closing out the position before expiration?

Yes, of course, in a vertical spread, the closer-to-the-money calls you are long should move more than the OTM calls that are short. And yes, the position can be closed prior to expiration for a profit.

But if there is more than two weeks remaining, that profit might leave one dissatisfied, because it will be significantly smaller relative to the price change of the underlying stock. That is because the components that affect an options price, such as time, volatility and even the underlying price, tend to be similar on both strikes. The result is the value of the spread will stay fairly flat unless it goes deep ITM or there is less than 10 days until expiration.

Let's look at a quick example. On Friday, with shares of

Best Buy

(BBY) - Get Report

trading at $52, the July $50/$55 call spread with 48 days remaining until expiration was trading around $2.40 for the spread. The $50 call has a delta of 0.70, and the $55 call has a delta of 0.35. That gives the position a net long delta of 0.35.

That means you can expect to "make" 35 cents for every $1 move in the underlying. (For more information on options terms like delta, check out our free

options glossary.

) Now, let's assume shares of BBY move up to $56 on July 1, or four weeks from now. Using our handy

options calculator and assuming that implied volatility remains around the 35% level, the $50 call would be worth around $6.30, and has a 0.89 delta; the $55 call would be trading around $2.60, with a 0.59 delta.

Now, let's assume shares of Best Buy move to $56 four weeks later. The $50 call is now worth $6.30 and has a 0.89 delta and the $55 call is trading around $2.60 with a 0.59 delta.

So the spread is trading around $3.70, or a $1.30 increase on a $4 price move. Sounds like 35 cents to the dollar to me. But guess what -- the net delta on the spread has actually declined to 0.30. Meaning as it moves deeper into the money, it will only realize an incremental smaller increase in value. It can be very frustrating.

An important concept to keep in mind when trading vertical spreads is that in-the-money spreads benefit from time decay or a decline in implied volatility, which are essentially the same thing, whereas OTM spreads benefit from an increase in IV. If you expect a moderate move in the near term, use strikes that are in or at expect a large price move over an extended period, use an OTM spread. the money. If you

For more on spreads, check out our free report,

Wealth-Building Options Strategies

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Steven Smith writes regularly for TheStreet.com. In keeping with TSC's editorial policy, he doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships. He was a seatholding member of the Chicago Board of Trade (CBOT) and the Chicago Board Options Exchange (CBOE) from May 1989 to August 1995. During that six-year period, he traded multiple markets for his own personal account and acted as an executing broker for third-party accounts. He appreciates your feedback;

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