Tactics

2. Tactics Vertical Spreads

3. What are Verticals Vertical spreads are typically defined as two-legged option strategies with different strike prices but the same expiration date.

4. Vertical Spread Types • Credit Spreads • Bear Call • Bull Put • Debit Spreads • Bull Call • Bear Put

5. Primary Use • Directional trading tools • Can use Vega or Theta for advantage • Verticals have controlled risks

6. Credit Spreads • Uses the same expiration for all options • Net credit for the trade • Typically sell OTM option • Protect with cheaper option further OTM • Theta is an advantage • Short Vega • Rising IV typically hurts this position • Drop in IV may allow an early exit • Look for High IV relative to the Forecast Volatility • Clear direction is an advantage • Can win even if stock moves a little against direction

7. Bear Call Scenario Scenario • Stock XYZ has had a gap down on bad news and we expect it to fall further • This news has exposed significant weakness in the stock • It is currently trading at $52.53 • The following month options set to expire in 38 days • IV is high because of the news (~51%) • Historically this stock has never had a measured historical volatility greater than 42%

8. Bear Call Trade • Sell an Out of the Money Call (60 Strike @ .60) • I chose a Delta of .19 • Far enough away to be safe from a minor retracement • Close enough to capture decent profit • This is your judgment call • Protect by buying further OTM Call (65 strike @ .28) • Tighter strikes lower risk, but also have a lower return • In general tighter is better, until commissions take up too high a % of the credit • Total credit => .60 - .28 = .32 • Factor in commissions also • Margin for this trade equals the risk • Max loss = $5 (difference between strikes) • Max Loss is offset by the credit you get ($.32) • Margin => 5.00 – 0.32 = $4.68 • Return on Margin = .32/4.68 = 6.8%

9. Bear Call Analysis • What is my Max Risk? • The difference in the strikes used minus the credit received • This is normally the margin requirement for trade • Am I getting enough credit to take the risk of the trade going against me? • Max loss is often much larger than the profit of the trade • % chance of winning is normally high • Compare IV to Historical Volatility – High IV relative to Historical Volatility is a good sign for this trade (1.2 or higher is a good ratio) • Higher Historical Volatility means higher probability this goes against me.

10. Bear Call - Greeks • Theta • Short 60 Strike Call has a Theta of 0.0278 • Long 65 Strike Call has a Theta of -0.0175 • At this point in time we will be making ~0.0103 per day (3%) • This effect increases as we get close to expiration • Vega • Short 60 Strike Call has a Vega of -0.0514 • Long 65 Strike Call has a Vega of 0.0312 • At this point in time we will lose -0.0202 (-6%) for each 1% increase in the IV or gain if it goes down • This effect decreases as we get closer to expiration • Delta • Short 60 Strike Call has a Delta of -0.2157 • Long 65 Strike Call has a Delta of 0.1004 • At this point in time we will lose -0.1153 (-36%) for each dollar that XYZ gains • The effect of Delta will be greatest when our short strike is at the money

11. Credit Spread- Tips • Time • Shorter duration trades • Most efficient with 45 days or less to expiration • Use the high Theta to your advantage • Volatility • Look for IV Higher than the forecast volatility • IV should be near the high end of its normal range • Careful of outrageous IV – often a signal of a big move that may be in a direction you don’t expect • Avoid major events (i.e. earnings, FDA announcements, etc…) • Exit & Management • Risk only a reasonable amount of your portfolio • Focus on the time value of the trade, what % are you making per day • Close the trade early when possible, use the margin for new trade (80% of max profit is my typical target)

12. Bear Calls - Specifics Remember that IV tends to increase on quick drops in stock price. This effect can reduce the profit on a Bear Call while you are holding the position. If the stock price goes up, IV will have a tendency to drop. This can protect you a little from the trade going against you and give you more time to effectively manage the trade. As expiration approaches, a high IV won’t matter as long as the stock closes below the strike of our short call.

13. Bull Put Scenario Scenario • Stock XYZ has been trending up on good performance • Expectations are solid • It is currently trading at $32.48 • No big events or risky announcements • The following month options set to expire in 38 days • IV is in upper 1/3 of its range excluding earnings announcements (35%) • Historical volatility is near 24%

14. Bull Put Trade • Sell an Out of the Money Put (30 Strike @ .52) • I chose a Delta of .22 • Far enough away to be safe from a minor retracement • Close enough to capture decent profit • Closer to stock price = Higher Risk + Higher Reward • Protect by buying further OTM Call (29 strike @ .35) • Tighter strikes lower risk and lower margin, but also have a lower return • Watch the % of your profits commissions consume • Total credit => .52 - .35 = .17 • Factor in commissions also • Margin for this trade equals the risk • Max loss = $1 (difference between strikes) • Max Loss is offset by the credit you get ($.17) • Margin => 1.00 – 0.17 = $0.83 • Return on Margin = .17/.83 = 20.4% (better trade)

15. Bull Put Analysis • Same as Bear Call • What is my Max Risk? • The difference in the strikes used minus the credit received • This is normally the margin requirement for trade • Am I getting enough credit to take the risk of the trade going against me? • Max loss is often much larger than the profit of the trade • % chance of winning is normally high • Compare IV to Historical Volatility – High IV relative to Historical Volatility is a good sign for this trade (1.2 or higher is a good ratio) • Higher Historical Volatility means higher probability this goes against me.

16. Bull Put - Greeks • Theta • Short 30 Strike Put has a Theta of 0.015 • Long 29 Strike Put has a Theta of -0.012 • At this point in time we will be making ~0.003 per day (1.7% of Max Profit) • This effect increases as we get close to expiration • Vega • Short 30 Strike Put has a Vega of -0.032 • Long 29 Strike Put has a Vega of 0.025 • At this point in time we will lose -0.007 (-4%) for each 1% increase in the IV or gain if it goes down • This effect decreases as we get closer to expiration • Delta • Short 30 Strike Put has a Delta of 0.223 • Long 29 Strike Put has a Delta of -0.156 • At this point in time we will gain 0.067 (39.4%) for each dollar that XYZ gains (lose if it goes down) • The effect of Delta will be greatest when our short strike is at the money

17. Bull Put - Specifics Remember that IV tends to decrease on rising stock prices. This effect can increase the rate at which you can capture the profit on a Bull Put Spread. IV will increase if the stock goes down and the trade goes against you. This will cause you to lose money faster than expected if the trade goes bad. As expiration approaches, a high IV wont matter as long as the stock closes above the strike of our short call.

18. Credit Spread Review • Credit Spreads are good ways to capture directional price movement when Implied Volatility is overpriced in the options. • Situations where the IV is higher than the forecast volatility can give us an edge in Credit Spreads. • We use both the expected directional price movement and time decay to our advantage. • Our goal should be to capture a portion of the max profit as quickly as possible, then reuse the margin for a new trade. • Credit Spreads can typically make money if the stock moves in the expected direction or does not move significantly against you. This typically gives you a high probability of success. • Most often the max risk of these trades is higher than the max gain, but the high probability of success overcomes this deficiency.

19. Debit Spreads • In debit spreads you pay a net debit for the trade • You are net long options • Minimize Theta • Typically Long Vega - Rise in IV helps • Enter with a Low IV relative to the Forecast Volatility • Low IV makes this trade less expensive to enter

20. Bull Call Spread • Buy Long Call • Sell Higher Short Call to offset Costs • Expecting market to go Up • Minimize the trade cost • Low IV relative to the Forecast Volatility • Theta is your enemy • Use a long time to Expiration to give you slow Theta decay • Capped Profits • Limited Risk • Margin based on the debit for trade – possible to get High Leverage

21. Bull Call Scenario Scenario • Stock XYZ has been trending higher and we expect this to continue • Solid expectations for stock appreciation • Few threats of the price dropping • It is currently trading at $89.80 • The options we use are set to expire in 129 days • IV is low because of the confidence in the stock (~33%) • Historically Volatility on this stock is currently 40%

22. Bull Call Trade • Buy an At the Money Call (90 Strike @ 8.15) • Delta is roughly .55 • Lower Delta = Higher probability of success but higher downside risk and greater costs • This is your judgment call • Reduce cost by selling further OTM Call (95 strike @ 6.00) • Tighter strikes lower risk , increase the trade cost, but also have a higher possible return • The short strike is what limits your max profit • Total debit=> 8.15 – 6.00 = 2.15 • Factor in commissions also • Margin for this trade equals the debit amount • Max loss = $2.15 (cost of debit) • Max Return is the difference in strikes minus the debit amount • ($95 – $90) – $2.15 = $2.85 • Max Return on Margin = $2.85 / $2.15 = 132% (Big Win Potential)

23. Bull Call Analysis • What is my Max Risk? • The debit cost of the trade • This is the cost or margin requirement for trade • Am I getting enough profit to take the risk of the trade going against me? • Max loss can be smaller than the Max Return - good • We will only be holding this trade for a portion of the options life • Likely return is far lower than max win need to estimate • Compare IV to Historical Volatility – Low IV relative to Historical Volatility is a good sign for this trade (.9 or lower is a good ratio) • Higher Historical Volatility means higher probability this trade goes in my favor

24. Bear Call - Greeks • Theta • Long 90 Strike Call has a Theta of -0.0313 • Short 95 Strike Call has a Theta of 0.0301 • At this point in time we will be losing -0.0012 per day – very small amount • This effect increases as we get deeper in or out of the money • Vega • Long 90 Strike Call has a Vega of 0.2127 • Short 95 Strike Call has a Vega of -0.2136 • At this point in time we will lose -0.0202 (-6%) for each 1% increase in the IV or gain if it goes down • This effect decreases as we get closer to expiration • Delta • Long 90 Strike Call has a Delta of -0.2157 • Short 95 Strike Call has a Delta of 0.1004 • At this point in time we will lose -0.1153 (-36%) for each dollar that XYZ gains • The effect of Delta will be greatest when our short strike is at the money

25. Bull Call Analysis • What is my Max Risk? • The debit cost of the trade • This is the cost or margin requirement for trade • Am I getting enough profit to take the risk of the trade going against me? • Max loss can be smaller than the Max Return - good • We will only be holding this trade for a portion of the options life • Likely return is far lower than max win need to estimate • % chance of winning is mid to low • need to overcome theta erosion • Need price movement relatively quickly • Compare IV to Historical Volatility – Low IV relative to Historical Volatility is a good sign for this trade (.9 or lower is a good ratio) • Higher Historical Volatility means higher probability this trade goes in my favor

26. Credit Spread- Tips • Time • Short duration trades (1-2 weeks) • Most efficient with 45 days or less to expiration • Use the high Theta to your advantage • Volatility • Look for IV Higher than the forecast volatility • IV should be near the high end of its normal range • Careful of outrageous IV – often a signal of a big move • Avoid major events (i.e. earnings, FDA announcements, etc…) • Exit & Management • Risk only a reasonable amount of your portfolio • Focus on the time value of the trade, what % are you making per day • Close the trade early when possible, use the margin for new trade (80% of max profit is my typical target)

27. Bear Calls - Specifics Remember that IV tends to increase on quick drops in stock price. This effect can reduce the profit on a Bear Call while you are holding the position. If the stock price goes up, IV will have a tendency to drop. This can protect you a little from the trade going against you and give you more time to effectively manage the trade. As expiration approaches, a high IV won’t matter as long as the stock closes below the strike of our short call.

28. Bear Put Spread • Buy Long Put • Sell Lower Short Put to offset Costs • Expecting market to go Down • Minimize the trade cost • Low IV relative to the Forecast Volatility • Theta is your enemy • Use a long time to Expiration to give you slow Theta decay • Capped Profits • Limited Risk • Margin based on the debit for trade – possible to get High Leverage

29. Debit Spread Review • Debit Spreads are good ways to capture directional price movement when Implied Volatility is underpriced in the options. • Situations where the IV is lower than the forecast volatility can give us an edge in Debit Spreads. • We use the expected directional price movement to our advantage. • Our goal should be to capture a portion of the max profit as quickly as possible, then reuse the margin for a new trade. • Debit Spreads are typically used to make money if the stock moves in the expected direction and does not move significantly against you. These are typically higher return trades with a lower probability of success. • Most often the max risk of these trades is lower than the max gain, but the low probability of success reduces this advantage.