CHAPTER 9
Vertical Spreads
Risk—it is the focal point around which all trading revolves. It may seem as
if profit should be occupying this seat, as most important to trading options,
but without risk, there would be no profit! As traders, we must always look
for ways to mitigate, eliminate, preempt, and simply avoid as much risk as
possible in our pursuit of success without diluting opportunity. Risk must be
controlled. Trading vertical spreads takes us one step further in this quest.
The basic strategies discussed in Chapters 4 and 5 have strengths when
compared with pure linear trading in the equity markets. But they have
weaknesses, too. Consider the covered call, one of the most popular option
strategies.
A covered call is best used as an augmentation to an investment plan. It
can be used to generate income on an investment holding, as an entrance
strategy into a stock, or as an exit strategy out of a stock. But from a trading
perspective, one can often find better ways to trade such a forecast.
If the forecast on a stock is neutral to moderately bullish, accepting the
risk of stock ownership is often unwise. There is always the chance that the
stock could collapse. In many cases, this is an unreasonable risk to assume.
To some extent, we can make the same case for the long call, short put,
naked call, and the like. In certain scenarios, each of these basic strategies is
accompanied with unwanted risks that serve no beneficial purpose to the
trader but can potentially cause harm. In many situations, a vertical spread
is a better alternative to these basic spreads. Vertical spreads allow a trader
to limit potential directional risk, limit theta and vega risk, free up margin,
and generally manage capital more efficiently.