Options Trading In Motion: The 1 by 2 Vertical Options Spread

trading optionsLooks like a bit of a bounce this morning. I wouldn’t make too much of that, though, as Tuesday is often a counter trend day. But, hey, market prognostication isn’t exactly my area of expertise. But, options education is. So, after looking at a 2 by 1 spread yesterday using puts, let’s look at a 1 by 2 vertical options spread using calls.

Normally I do not like being net options short. But, if one has a high-risk tolerance and keeps a close eye on the position there is a good chance of making money using time decay.

Which brings me to an interesting trade setup, the 1:2 ratio vertical options spread. This trade includes one out of the money option long and two further out of the money options short. One is looking to do this for a credit.

Let’s take a look at Apple (AAPL) for an example. With the stock trading at 524, perhaps we will see a modest move higher in the next month or so. So, let’s buy 1 May 535 call at its current price of 12.50 and sell 2 January 545 at it’s current price of 8. This gives us a net credit of 3.50 or $350 for each 1:2.

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Where does this position make the most money and how much? Where does the position start to lose money? Remember, you are one net option short. And where is the breakeven?

There is no downside risk because if both strikes expire worthless you collect the credit. Option positions make the most when expiration is on the short strike. So the point of maximum profit is 545. If the 545 call goes out worthless, we collect $1600 (8 x 2) while the 535 is worth 10, costing us $250 for a total profit of $1350 for every time we did the trade. Being net short calls we will start losing money somewhere. The rule of thumb for calculating the losing point is at the next equidistant strike further OTM plus in the credit received. So, the position starts losing with AAPL at 548.50, or 4.67% higher than where AAPL is now. And that level is also the breakeven price in the position.

So, we see that while not without risk, the 1:2 vertical options spread is a profitable trade when the underlying value makes a modest move. Beware, though, that the net short option requires extra margin and the position is vulnerable to a large gap move.

Twitter:  @RandallLiss

This post is from Randall’s site, The Liss Report.

No positions in any of the mentioned securities at the time of publication.  Any opinions expressed herein are solely those of the author, and do not in any way represent the views or opinions of any other person or entity.