How Could Vertical Spreads Help Your Strategy?

July 18, 2023
Find out how vertical spreads could change your risk profile and margin requirements.

Let's say you're short a single put option, and the market has been chopping along, maybe grinding higher. Unless implied volatility has been steadily climbing, you're probably sitting on an unrealized gain. Getting nervous about whether your good fortune might continue?

Unless you have approval to trade uncovered ("naked") options (more on that in a bit), your short put requirement was about the same as buying the stock outright—only with the short put, you aren't entitled to any dividends that might be paid, and you have no voting rights. However, you still need to have enough capital in your account to cover the purchase of the stock in case you get assigned (this is called a "cash-secured" put). And remember, a short equity option can be assigned at any time up until expiration, regardless of the in-the-money status.

Looking for a way to reduce downside risk in your current position without giving up too much of your potential profit? If you have a margin account approved for spread trading (Level 2 at Schwab), there's a way.

The strategy: Turn it into a bullish vertical spread by buying a lower-strike put.

As mentioned above, since the requirements for selling a cash-secured put are about the same as buying the stock outright, it can be quite capital intensive. The requirement equals the risk, which is the difference between the strike price (the price at which you'd be obligated to buy the stock if you're assigned) and zero. But with many stocks it can be a long way to zero.

Perhaps it's time to think vertically.

Turning a short option into a vertical spread? Add a leg

A put vertical spread is long one put option and short another put option at different strike prices in the same underlying asset, with the same expiration date. Usually both legs of a vertical spread are established simultaneously, but you can create the same position by buying an option (a long put) that's further out of the money than the existing short put position.

First, let's look at a graphic illustration of two risk profiles—the cash-secured put and the bullish put vertical spread—followed by an example with numbers.

FIGURE 1: RISK PROFILES OF A SHORT PUT AND BULLISH PUT VERTICAL SPREAD

Graphic that shows how buying a lower-strike put turns a short single-leg put into a lower-risk spread.

Note that buying a lower-strike put turns a short single-leg put into a lower-risk spread. For illustrative purposes only.

Let's say a week ago you sold a 134-strike put option for $1.10, and now it's trading at $0.83. The position has been working in your favor, but you'd like to reduce your risk and lower the margin requirement without closing the position.

In this case, you could buy the 130-strike put for $0.25, which would create a 134/130 bullish put vertical spread, for a combined net credit of $0.85. That's calculated by taking the original $1.10 premium you received a week ago, minus the $0.25 premium you just paid for the 130 put. The maximum risk of a bullish put vertical spread is the difference between the two strikes minus the net premium—$4 minus $0.85, or $3.15. And remember to include the multiplier (typically 100) for standard U.S. equities, as well as transaction costs.1

In summary: ((134-130) - ($1.10 - $0.25)) x 100 = $315 (plus transaction costs) in risk and a potential profit of $85 (minus transaction costs) vs. a potential profit of $110 in the original trade.
 

Remember the kicker: Requirement reduction

The initial requirement for selling a single 134-strike cash-secured put is its strike price times the multiplier, or ($134 x 100) = $13,400. After the order is executed, the $110 credit received can be combined with $13,290 in cash to make up the $13,400 total.

If executed in a margin account, the new margin requirement for the bullish 134/130 put vertical spread is the difference between the strikes x $100, or: (134-130) x $100 = $400.

In this example, while the assignment risk of the short leg remains the same, turning the cash-secured put into a bullish put vertical spread lowered your potential profit by $25, but reduced your requirement by roughly $12,890 (from $13,290 to $400).

Here's an overview of requirements for these examples.

Here's an overview of requirements for these examples.

Figure 1: Risk profile of a short put and a short put vertical spread

Here’s an overview of requirements for these examples. Also, remember to multiply the options premium by 100, the multiplier for
  • Account type
  • Approval level
  • Cash-secured put
  • Account type
    Cash
  • Approval level
    Level 0
  • Vertical spread
  • Account type
    Margin
  • Approval level
    Level 2
  • Naked put
  • Account type
    Margin
  • Approval level
    Level 3

Also, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So, an options premium of $1 is really $100 per contract.

Non-standard options may have different multipliers or deliverables. Make sure you understand the terms before trading.

Also, remember to multiply the options premium by 100, the multiplier for standard U.S. equity options contracts. So, an options premium of $1 is really $100 per contract.

Non-standard options may have different multipliers or deliverables. Make sure you understand the terms before trading.

Margin and Levels of Options Approval

Without naked options approval (Level 3 at Schwab) in a margin account, you can't sell naked puts and instead can only sell puts that are cash secured. Doing that, as you can see from the above example, is capital intensive. By the way, selling cash-secured puts requires Level 0 options approval or higher at Schwab.

Bottom Line on Selling Single-Leg vs. Vertical Spreads

Capital preservation and capital efficiency are two cornerstones of options trading. By vastly reducing a margin requirement through the use of a vertical spread, you can free up funds for another trading opportunity. The intensive capital requirements associated with selling naked options can also be cost-prohibitive even for those with margin accounts and naked options approval. Also, naked options trading involves substantially more risk.

A few things to keep in mind:

  • Spread trading can only be done in a margin account
  • Many account types do not qualify for margin
  • Increased leverage significantly increases risk

So, the next time you're short a single-leg option and looking to potentially reduce your risk, consider turning that short option into a lower-risk vertical spread—and you'll even free up some trading capital in the process.

1Typical Schwab online commission charges are $0.65 per contract. All broker-assisted and automated phone trades are subject to service charges. See the Charles Schwab Pricing Guide for details.

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Looking to the Futures

April Natural gas futures (NGJ24) ended Friday’s session lower, as gas storage levels remain well above the five-year average.

Today's Options Market Update

In addition to any insight from Fed officials on the PCE data, the latest Michigan sentiment survey should give a peak into consumers' views on inflation and jobs.

Weekly Trader's Outlook

Investors approved of this week's inflation read and responded by pushing most of the major indices to fresh all-time highs. Although we're overbought, the near-term path of least resistance appears to be higher.

Options carry a high level of risk and are not suitable for all investors. Certain requirements must be met to trade options through Schwab. Please read the options disclosure document titled "Characteristics and Risks of Standardized Options." Supporting documentation for any claims or statistical information is available upon request.

Commissions, taxes and transaction costs are not included in this discussion but can affect final outcome and should be considered. Please contact a tax advisor for the tax implications involved in these strategies.

With long options, investors may lose 100% of funds invested. Multiple leg options strategies will involve multiple commissions. Spread trading must be done in a margin account. Writing uncovered options involves potentially unlimited risk.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Examples provided are for illustrative purposes only and not intended to be reflective of results you can expect to achieve.

Margin borrowing may not be right for everyone. It's important that you fully understand your financial situation, the rules of margin borrowing, and conditions that may affect your investments.

Before you begin using margin, you should read Schwab's Margin Borrowing Overview and Disclosure Statement. To learn more or refresh your knowledge about margin lending you can refer to The Schwab Guide to Margin.

When considering a margin loan, you should determine how the use of margin fits your own investment philosophy. Because of the risks involved, it is important that you fully understand the rules and requirements involved in trading securities on margin. Margin trading increases your level of market risk. Your downside is not limited to the collateral value in your margin account. Schwab may initiate the sale of any securities in your account, without contacting you, to meet a margin call. Schwab may increase its "house" maintenance margin requirements at any time and is not required to provide you with advance written notice. You are not entitled to an extension of time on a margin call.

Past performance is no guarantee of future results.

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