The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.
NEW YORK (
) -- Let's discuss an options strategy that often is overlooked.
Besides covered calls and cash-secured naked puts (which have the same risk profile, by the way), one of the most basic spread constructions available to option traders is the vertical spread.
A vertical spread can be written when an option trader believes prices are going up (bull call spread) or when prices are going down (bear put spread).
In addition to those debit trades, option traders also have the ability to place vertical credit spreads.
All types of vertical spreads are a very basic option trading strategy, but they can produce strong returns with defined risk.
A brief description of a vertical debit spread involves buying a call or put and simultaneously selling a strike farther away from the money.
Vertical debit spreads always have a directional bias depending on whether calls or puts or used.
The sale of the call or put that is further away from the money results in a credit and helps reduce the total cost of the spread, thereby reducing the capital risk.
A call debit spread, also called a bull call spread, is used when a trader expects higher prices. A put debit spread, also called a bear put spread, is utilized when the option trader expects lower prices.
A vertical credit spread is established in the opposite manner. The construction involves selling a call or put that is closer to the money and buying a strike that is farther away from the money.
This strategy profits from time decay as well as price action. The maximum gain is limited to the difference in the credit received for the contract that is sold and the debited premium that is required to purchase the long strike.
Vertical credit spreads always result in a trader receiving a credit. A call credit spread, also known as a bear call spread, is used when an options trader is expecting lower prices. A put credit spread, also known as a bull put spread, is utilized when an options trader expects higher prices.
I typically use vertical debit spreads when I want to place a trade that has defined risk and I expect an underlying asset's price action to move in a specific direction.
However, vertical credit spreads are often overlooked by many traders, and this is most certainly a mistake. My favorite time to utilize a vertical credit spread is when price action across the equity indices is ugly.
In fact, a nasty selloff where implied volatility is juiced in most equities presents an outstanding opportunity to construct vertical credit spreads.
With the commodity complex getting hammered recently as the dollar strengthened, a lot of the agriculture-based companies have suffered.
As an example, the exchange-traded fund
Market Vectors Agribusiness
has lost close to 10% from its recent highs. I was stalking this ETF, looking for a bottom in the price action, and on May 23 I looked on as MOO was close to testing its 200-period moving average shown below:
I had also been stalking
for a while, looking for a bottom. As it turns out, Deere is the single largest individual holding in the MOO ETF.
When I saw MOO bounce near its 200-period moving average while DE closed in on its 200-period moving average, I felt that we were near a short- to intermediate term bottom in the agriculture space.
I immediately looked at the DE option chain as well as the historical implied volatility chart. The trade offered solid risk definition, because the 200-period moving average was my support level and redit spreads offer an option trader precise capital risk attributes.
Because Deere had been under significant selling pressure, implied volatility was elevated, which would also put the wind at my back. When writing credit spreads, implied volatility is critical and must be monitored. I knew I was selling juiced option premium as the implied volatility was historically elevated.
The closest at-the-money strike on the put side was the June DE 80 Put contract. I proceeded to sell the June DE 80 Put contracts and bought the June DE 77.50 Put contracts in a 1-1 ratio to set up the spread.
The maximum risk per put credit spread was $197. The maximum gain was $53 per spread. At expiration, the maximum yield would be earned if DE closed at $80 a share or more. The maximum yield of the trade would be 27% (53/197) based on maximum risk. The profitability curve of the DE Put Credit Spread is shown below.
I had absolutely no intention of holding this trade to expiration. In fact, my trading plan was to close the trade as soon as it reached a 15% return based on maximum risk. I employed a hard stop based on the underlying Deere stock price of $80.90.
Essentially, the trade had a 1-1 risk vs. reward ratio (also referred to by traders as a 1R trade). I still had the trade open as of Friday morning, but with the higher prices I saw that morning, I decided to close the trade with a gain near 15% of my maximum risk and 100% of my hard stop-based risk.
Options traders often overlook basic trading strategies like a vertical credit spread. This kind of spread offers solid risk/reward in a stock market correction or in a situation where a particular underlying security has been under selling pressure for quite some time, implied volatility is juiced and a major support/resistance level is nearby.
Vertical spreads allow options traders to trade around bounces, topping patterns and bottoming patterns without the total capital risk associated with buying or shorting stock.