Options Trading Tutorial

If you are exhausted from reading charts and if you find analyzing financial statements a complete bore, then maybe there is another game for you – trading the odds. This is a simple and clear-cut strategy for staying on the side of the “smart money”.

In the options world trading the odds was once considered a professional’s game; however, with the dawn of computers and real-time data transmission, more and more retail traders have revealed the benefits of trading the odds. This approach is nothing new; after all, poker players have understood the odds for millennia. The next time you place a trade, ask yourself, “what are the odds of success on this trade?”

As you dip your toe into the waters of trading probabilities, it is easy to see the benefits of selling options. Numerous studies have shown the vast majority of options expire out-of-the-money. But for those who step a bit deeper into those murky waters and assume that it is always better to sell options than to buy, you are making a mistake. Options sellers win more often because they enjoy a higher probability of success. Option buyers, on the other hand, pay a premium for limiting their risk and therefore accept a lower chance of success.

Selling option premiums can be compared to selling insurance: it can be a lucrative business plan but you better have a good reinsurance plan when the hurricane hits. Because probabilities are so easy to grasp, traders often overlook the next blow-up that may occur in the real world.

For instance, it is very tempting to sell deep out-of-the-money calls and puts since the odds of success are so high. A short strangle involves selling an out-of-the-money call option and an out-of-the-money put option on the same underlying asset with the same expiration date. To manage risk, the options are written far out-of-the-money so that the chances of the market price breaching the call or put strike price, by expiration date, are greatly reduced.

Picking the strike price and duration for an option contract is a very simple decision when trading the odds. Since time is working with the trade, i.e., time decay is a welcomed ingredient, one is inclined to pick an expiration that is close to expiration. Next, a calculation or Greek term called ‘delta’ is applied to determine the probability of an option retiring in-the-money at expiration. A trader may simply pick a delta that is within his threshold of risk.

For instance, let’s assume I wish to sell a short strangle that has a 90% chance or better of expiring worthless. I simply scan for a delta that is 10% or less on the call and 10% or less on the put. Recall that it is impossible for the stock to close above and below both thresholds on expiration, so one leg or one-half of the straddles is always a winning play.

In this example, there is a 5.7% chance that the call option will expire at or above the upper threshold and a 6.2% chance that the put option will expire at or below the lower threshold. Thus, there is an 88.10% (100% – 6.2% – 5.7%) chance that the stock price will close inside the boundaries. Are you comfortable with these odds?

A trader may also use the probabilities to adjust an existence trade. For instance, some option traders will close one leg of the short straddle if the delta or the probabilities improve to 40%.

You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). http://woas.zacks.com/adv/method/mto_long.php?adid=ZMTO_HP_ARTPG

And be sure to check out our new Zacks Options Trader. https://www.zacks.com/registration/optionstrader/welcome/?adid=SC_online_TSleftnav

Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.

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How To Trade Oil Futures Options

One of the problems facing someone wishing to trade futures contracts on oil is the margin required can be very large, requiring a large trading account and also presenting a large risk when trading. How To Trade Oil Futures Options

A very simple solution to the problem is to purchase options on the underlying oil contract. The advantages to the trader are, the amounts required to trade are smaller, hence you can trade with a smaller account and the dollar value of the risk is known (and smaller) and defined prior to placing the trade.

Purchasing options for this for this reason is not new. The concept can be applied to any commodity or stock and is known as directional trading. Below we describe the concept with some detail.

An OPTION is the right but not obligation to sell (a PUT option) or buy (a CALL option) one contract of the underlying equity (in this case a contract of crude oil, 1000 barrels) at a certain price (called the strike price) by a certain time (this is called the option expiry date, do not confuse that with the contract expiry date).

You as the option buyer pay a premium to the option seller for this right. How you make your income is if the price of the underlying oil contract moves in your favor, the value of the option moves in your favor, that is it becomes worth more.

For example, if your analysis indicated that the price was going to go up you would purchase a CALL option if you believed the price were going to go down you would purchase a PUT option. This is why it is known as directional trading. The value of the option will only increase if the price of the oil goes up or down, that is, if the price of the oil contract does not move up or down then your bought option will not gain in value and you will not make any money. How To Trade Oil Futures Options

To help you understand that we will give brief description of what makes up the value of an option. The premium charged by the seller of the option is made up of two main components. They are extrinsic value and intrinsic value. You as the option purchaser for the purpose of buying options on crude oil are looking for the intrinsic value of the option to increase. For the record the extrinsic value is made up of two components, time value (as the option gets closer to expiry this decays exponentially) and volatility.

The intrinsic value of the option is just the difference between the futures contract price and the option strike price. So if you believe the price is going to increase you would purchase a call option and if the futures price increased so would the intrinsic value of the option, meaning the option is now worth more and can be sold back to the market to realize the profit.

Similarly if you believed the price was going to drop you would purchase a put option. As the price drops the value of your option increases and you can sell it back to the market and realize a gain.

The maximum risk of your trade is what you paid for the option, which you know before you place the trade and can determine if it fits with your money management rules. How To Trade Oil Futures Options

There are two main types of vertical spreads. There is the vertical call spread and the vertical put spread. Each spread allows you to do two things. First, you can buy it, making you long the vertical spread. Second, you can sell it making you short the vertical spread. Both can be employed to take advantage of directional stock plays. When we use the term ‘directional stock play,’ we refer to using vertical spreads to capitalize on anticipated stock movements either up or down.

A bull spread is used when the investor feels that a stock is most likely to go up. As we recall, ‘bullish’ means to have a positive outlook on a stock’s future movement. There are two ways to set up a bull spread. The first is with the use of calls. In this case, a bullish investor would buy a vertical call spread (bull call spread). This is accomplished by buying a call with a lower strike price and selling a call with a higher strike price.

The second way to construct a bull spread is with the use of puts. A bullish investor could sell a vertical put spread (bull put spread) hoping to profit from an increase in the stock’s value. The investor would sell a put with a higher strike price and buy a put with a lower strike price. Let’s take a look at how the P&L chart of a Bull Spread looks below.

To recap, if you feel a stock will be increasing in value, you may put on a bull spread by either buying a vertical call spread (bull call spread) or selling a vertical put spread (bull put spread)

A bear spread, however, is used when, you the investor, feels a stock is likely to trade down. Remember, ‘bearish’ means that one’s outlook on the future movement of the stock is negative. To take advantage of this expected downward movement, the investor would put on a bear spread. This can be done in either of two ways.

First, the investor can do it using puts. The purchase of a vertical put spread (bear put spread) can be accomplished by purchasing a put with a higher priced strike and selling a put with a lower priced strike.

The second way an investor can construct a bear spread is by using calls, specifically, by selling a vertical call spread (bear call spread). You do this by selling a call with a lower strike price and purchasing a call with a higher strike price.

So if you think that a stock is likely to decrease in value, you sell a vertical call spread (bear call spread) or purchase a vertical put spread (bear put spread). Let’s take a look at the P&L diagram for a Bear Spread below.

Finally, there are two fundamentals that are universal to all vertical spreads. These fundamentals are critical to understanding the foundation of the vertical spread strategy: (1) you can determine a vertical spread’s maximum value by taking note of the difference between the two strikes and (2) vertical spreads have intrinsic value.

Let’s put together what we’ve been talking about, develop an imaginary spread scenario and set it in real life events.

In October, let’s say that you begin to hear about IJK stock. It looks interesting, so you then use a variety of sources to learn about IJK: news, charts, outside analysts, internet research etc. From your investigations you decide that this stock is poised for a strong upward move and you’d like to take advantage of it.

However, each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.

Now is the time to investigate IJK spreads. Since you are bullish on the stock, you investigate the bullish plays of the call spreads and the put spreads. You check the pricing of both since you are aware that implied volatility and time decay will affect both your purchase price and your selling price if you decide to sell out the spread before expiration.

Let’s say that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. The spread is called Nov. 50-60. The spread’s cost is $3.50, which means you pay $3500 for the trade, inexpensive when you consider that to purchase 1000 shares of IJK stock would have cost you $50,000! Now, you wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.

First, if the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you lose the $3500 that you paid for the spread. Second, if the stock begins to move up, you first recoup your investment and then move into profits. After the stock has moved up $3.50 you are at the breakeven point. Every money advance after that represents profit.

The chart below represents the spread’s losses and gains and your total profit

This chart is based on stock prices at expiration Friday in November. Until then the spread’s value fluctuates between $0 and its maximum (the difference between strike prices) of $10.00

At any time until expiration, you can sell out of the spread but what you receive for the price may be influenced by implied volatility and time decay and that will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3500 investment is $6500.

You paid $3500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6500 profit which is a 186% return.

If you had invested $50,000 for 1000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.

For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

It is important to remember that the time spread will leave you with several potential positions that can be altered by other options or stock in numerous ways.

There are a number of decisions you must make to clarify your understanding and goals. Being open to a number decisions can be a very good thing for the flexibility of your position, whether entering or exiting trades. In this example we’ll look at the position you have and the ways you can make your decisions.

First, it is important to understand what position you are going to be left with when the near-month option expires.

Second, you must form your opinion of what you think the stock is going to do (formulate a bullish or bearish lean) and then figure out the best way to take advantage of that opinion.

Next, you must figure out how to adjust your present position and change it into an advantageous position for a profitable outcome. That might mean selling out of the position totally. Your changes to the position must not only be correct, but also done in the most efficient, cost-effective manner including keeping commission prices down.

It is also important to note that you should make sure to go from a hedged position to another hedged position to ensure proper risk management.

Concluding Thoughts

The time spread is an excellent strategy for premium sellers who want to capture premium in a hedged way. It is best used in stagnant periods when a stock is likely to remain in a tight price range. It is less expensive and less risky than most other premium collecting strategies thus is friendlier to investors who are short on capital and experience. It can also be used to take advantage of volatility changes and even some directional stock movements.

The time spread can leave you with a residual naked position that needs to be managed for risk at expiration of the front month option. As always, it is important to fully understand the risks and rewards of the strategy and the potential risks and solutions of the residual position before executing the strategy. Don’t take this too lightly.

The residual position does allow you many choices including closing out the position totally, or continuing the position by combining it with either stock or another option to create a new position that fits the investor’s new expectations for the stock.

Time spreads can be a profitable investment strategy if you understand the concept of time decay. A time spread is designed to take advantage of the fact that an options decay curve is non-linear, that is, an option’s value does not decay evenly over time. As an option gets closer to expiration, its rate of decay increases meaning the option loses value more quickly. That decay rate increases progressively until expiration.

An option’s decay rate begins to accelerate when the option is about 45 days out. It picks up steam at 30 days out and really comes under decay pressure at about 15 days out. This scenario is similar to a boulder rolling down from a hilltop. As it starts, it rolls slowly, then gains more speed, and momentum the further it gets down the hill until it achieves its maximum speed at the bottom. Option decay acts the same way – gathering speed and momentum as the option approaches expiration.

In time spreads, both options have the same strike price that remains constant. Each option’s value decays at different rates and over different lengths of time. The option, with one month until expiration, experiences value decay at a faster rate than the one with three months until expiration.

If you buy an option with three months to go and sell an option with the same strike but with one month to go, you have set up a spread between the two options values (prices). As time passes, your short option loses value more quickly than your long option that decays more slowly. The value of the spread widens and you profit from that spread’s expansion. This is the fundamental behavior of the time-spread.

Consider that you are long the 60-30 day time spread. That means you are long the 60-day option and short the 30-day option. We will assign a price of $3.00 to the 60-day option and $2.00 to the 30-day option. Since you pay for the one and receive payment for the other, the bottom line cost of what you put out for the spread is $1.00.

During the same 30-day period, it goes from $3.00 to $2.00. Remember, the spread’s bottom line cost was $1.00. The 30-day option (now expired) will be worth $0 while the 60-day option (now a 30-day option) will be worth $2.00. If you had invested in this spread, after 30 days decay you would be holding one option worth $2.00. The investment has provided a nice return!

This is an ideal situation. The stock price and volatility remain constant and you capture the decay. The time spread has worked just as it should. It does work that way sometimes, but nothing works as it should all the time. As we know, stock prices and volatility levels do not remain constant. They are always changing. In the time spread strategy, the investor must choose opportunities carefully. In addition to picking a stock that will be in a stagnant period, the investor should look for two other situations where the spread has profit possibilities: changes in volatility and to a lesser degree stock price movements.

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Another protective strategy that allows for some upside capital gain while providing maximum down side protection is the collar.

The collar is a combination of the covered call and protective put strategies. The collar uses a long put position in coordination with a short call position along with a long stock position. The ratio is one short call, one long put (not of the same strike) and 100 shares of stock.

As you remember, one contract is equal to 100 shares. The options that we will use to construct this strategy will be out-of-the-money puts and calls.

The object here is to construct a protective put strategy without having to pay for the purchase of the put. We talked about premium in the covered call strategy and how we are better off collecting premiums over a period of time, not paying them out. By selling the call, we collect premium which can be used to offset the capital outlay we incurred for the put purchase.

We said that two of three scenarios in the covered call strategy were positive while the protective put scenario had only one scenario that produced a positive outcome. However, the protective put was the strategy that provided the most downside protection. The challenge was to construct a protective put strategy without paying out money. The solution is the collar strategy.

The collar takes on the characteristics of both the protective put and covered call strategies. Like the covered call, there is an upside cap on profits and like the protective put there is unlimited downside protection.

Ideally, the collar is set up to be an ‘even’ trade meaning you neither receive nor pay out any money. Realistically, depending on the options used, you may have to pay out a small premium or even receive a small premium but the goal of the collar in terms of premium is to be neutral.

As mentioned previously, to construct a collar, just buy one out-of-the-money put and sell one out-of-the-money call per every 100 shares of stock owned.

Obviously, the put and the call must be of differing strikes (it is impossible for a put and a call of identical strike price to both to be out-of-the-money or both to be in-the-money).

For example, with a stock priced at $28.50 a collar may be constructed by the purchase of the December 27.5 puts and the sale of the December 30 calls. Hopefully, the price of the call and put are close enough so that the funds generated by the sale of the call are enough to offset the cost of the put purchase.

Construction of a vertical spread occurs with the purchase and sale of a call (put) in the same stock and in the same month. The only difference between the two options is the strike price. For example, an investor would construct a vertical spread by purchasing the IBM June 55-call while selling the June IBM 60 call. This trade would be called the IBM June 55 – 60 call spread. Similarly, a purchase of the IBM July 45 put and sale of the IBM July 60 put would be called the IBM July 45 – 60 put spread.

The key to the constructing these vertical spreads is choosing options in the same stock and month, but different strikes and in a 1 to 1 ratio. That is, you must purchase one option for every one you sell or sell one option for every one you buy.

Value and the Vertical Spread

A vertical spread’s maximum value is the difference between the two strikes. For example, the maximum value of the June 55 60-call spread mentioned previously is $5.00. [60 - 55] = $5.

Spread- Difference in Strikes – Spread Maximum Value

August 35 – 40 call 5 $5.00

April 70 – 85 put 15 $15.00

Nov. 20 – 22.5 call 2.5 $2.50

Dec. 40 – 50 put 10 $10.00

Jan 60 – 80 call 20 $20.00

Using the June 55 – 60-call spread example, we will set the date to June expiration on Friday. On that day, all the June options will expire and the options will be worth parity, as all of the extrinsic value will have eroded away.

Where does the spread get its value? From its two components – the call (put) you buy or the call (put) you sell. Look at the spread’s value with a couple of different closing stock prices. If the stock closes at $55, then both the 55 strike and the 60 strike will be out of the money and worthless. The value of the spread will be zero since both options are worth $0. If the stock closes at $57.50, the June 55 calls will be worth $2.50. The June 60 calls will be out of the money and thus worthless, therefore the spread will be worth $2.50 (June 55 call $ 2.50 – June 60 call $0).

If the stock closes at $60.00, then the June 55 calls will be worth $5.00. Meanwhile, the June 60 calls will be worth $0. This means that the spread will be worth $5.00 (June 55 call $ 5.00 – June 60 call $0). This is the maximum value of the spread. Note that the maximum value is identical to the difference between the strikes.

As the stock goes higher, the June 60 call becomes in-the-money and gains intrinsic value. For every penny that the stock increases in value, the June 55 calls and June 60 calls gain value equally, keeping the $5.00 spread between the two strikes constant.

To see this, refer to the Table below.

Price- June 55 Call- June 60 Call- Spread

55 0 0 0

56 1 0 1

57 2 0 2

58 3 0 3

59 4 0 4

60 5 0 5

61 6 1 5

62 7 2 5

65 10 5 5

70 15 10 5

100 45 40 5

The difference between the strikes is the maximum value of all vertical spreads regardless of the distance between the two strikes. It does not matter whether the spread is $5.00 wide, $10.00 wide, $20.00 wide, or even $50.00 wide. Its maximum value is the difference between the two strikes. Further, the vertical spread’s maximum value (the difference between the two strikes) holds true for vertical put spreads as well as vertical call spreads. Look at our other example, the July 45 – 60 put spread.

Again we set time forward to Friday, July expiration. We set the stock closing price at $60.00. At $60.00, both the July 45 puts and the July 60 puts will be out of the money and thus worthless. With the July 45 puts and July 60 puts worthless, the spread is also worthless (July 60 put $0 – July 45 put $0). If the stock finishes at $52.50, then the July 60 puts will be worth $7.50 while the July 45 puts will still be worthless. In this scenario, the July 45 – 60 put spread will be worth $7.50 (July 60 puts $7.50 – July 45 puts $0). If the stock finishes at $45.00, then the July 60 puts will be worth $15.00 while the July 45 puts will be worth $0.

At this level, the spread is worth $15.00 (July 60 puts $15.00 – July 45 puts $0). This is the maximum value of the spread. As you can see, it is identical to the $15.00 difference between the strikes.

As the stock lowers, the July 45 puts become in the money and gain intrinsic value. For every penny that the stock decreases in value, the July 60 puts and the July 45 puts will gain value equally, keeping the $15.00 spread between the two strikes constant. To see this, refer to the table below.

Price- June 60 Put- July 45 Put- Spread

65 0 0 0

62 0 0 0

60 0 0 0

57 3 0 3

55 5 0 5

50 10 0 10

47 13 0 13

45 15 0 15

42 17 2 15

40 20 5 15

As stated, the maximum value of a vertical spread is the difference between the two strikes while the minimum value of the spread is, of course, $0. This means that in this strategy, both the buyer and the seller have a limited, fixed maximum loss.

The buyer can only lose what he spent. Therefore, if the buyer spent $2.20 to purchase the August 35 – 40-call spread, the most he can lose is the $2.20 he spent.

For the seller, the maximum loss is the difference between the maximum value of the spread (difference between the strikes) and the amount of money received for the sale of the spread. For example, if you were to sell the August 35 – 40-call spread for $2.20 then your maximum loss will be $2.80. Remember, the maximum value of the spread is the difference between the 2 strikes or $5.00 (40 – 35).

The difference between the maximum value of the spread ($5.00) and the amount the seller received for the sale ($2.20) leaves a $2.80 maximum loss.

Below, the chart shows the potential amount of money, both profit and loss, that can be made or lost by both the buyer and the seller.

Closing – Aug 35-40 Call Spread – Aug 35-40 Call Closing Price - Buyer P & L – Seller P & L

30 2.20 0 -2.20 +2.20

32 2.20 0 -2.20 +2.20

34 2.20 0 -2.20 +2.20

35 2.20 0 -2.20 +2.20

36 2.20 $1.00 -1.20 +1.20

37 2.20 $2.00 - .20 + .20

38 2.20 $3.00 + .80 - .80

39 2.20 $4.00 +1.80 -1.80

40 2.20 $5.00 +2.80 -2.80

42 2.20 $5.00 +2.80 -2.80

44 2.20 $5.00 +2.80 -2.80

46 2.20 $5.00 +2.80 -2.80

48 2.20 $5.00 +2.80 -2.80

50 2.20 $5.00 +2.80 -2.80

It is important to understand and remember that vertical spreads have both a limited profit and a limited loss scenario for both the buyer and the seller.

An investor must always keep in mind that vertical spreads have an intrinsic value. This means it is possible to consider them ‘in the money.’ If a vertical spread has an intrinsic value, it can also have an extrinsic value. Unlike maximum intrinsic values that equal the difference between the strikes at expiration, maximum extrinsic value deviates from spread to spread based on several factors.

During a vertical spread’s life, its price will fluctuate between zero and the value of the difference between the two strikes. An investor can determine the price of the spread, at any given time, by the location of the stock and the time until expiration.

At expiration, what remains for the two options is the intrinsic value of each. Therefore, the value of the spread is the difference between each option’s intrinsic values at expiration.

Because vertical spreads have an intrinsic value, the term ‘moneyness’ applies to them. Moneyness refers to whether or not and by how much an option, or a vertical spread, may be in the money or out of the money. This is a term used mostly by floor traders, but is still worth noting here.

Vertical Call Spread and Vertical Put Spread Value

Spreads with intrinsic value are considered in the money. How can you identify the value of a vertical call spread or a vertical put spread? Compare the stock price to the strike prices.

Look at any vertical call spread. If the stock price is above the lower strike of the spread, the spread is in the money. In the Feb. 50 – 55-call spread, if the stock is trading at $52.00, then the spread would be in the money by $2. This is because if the spread expired today, the Feb. 50 calls would finish $2.00 in the money. The Feb. 55 calls would finish worthless because they are out of the money. The spread, however, would be in the money with a value of $2.00.

The rule is similar for determining whether or not a spread is out of the money. If the stock price is lower than the lower strike of the spread, the spread is out of the money. Again, looking at the Feb. 50 – 55 call spread, if the spread expired today and the stock price closed at $48.00, (lower than the lower strike) then the spread would be out of the money, thus the spread will be out of the money. If the stock is trading at the same price as the lower strike price, the spread is considered at the money.

For vertical put spreads, a spread is determined to be in the money if the stock price is lower than the higher of the two strikes of the spread. For example, look at the Sept. 40 – 45 put spread. If the stock closes at $42.00 on expiration day, the Feb. 45 put would end up in the money and worth $3.00. The Feb 40 puts would be out of the money creating a $3.00 intrinsic value for the spread. Since the spread has an intrinsic value, it is in the money.

A vertical put spread is out of the money if the stock price is higher than the higher strike of the spread. So, going back to our Sept. 40 – 45 put spread example, if the stock was to close at a price of $46.00 (higher than the higher strike) then both the Sept. 40 and 45 put will expire worthless. Thus the spread will be worthless and out of the money.

A vertical put spread is considered at-the-money when the stock price is equal to the higher strike price.

During the life of a vertical call spread, the spread will trade between its minimum and maximum values (between 0 and the difference between the two strikes). In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.

Starting from a stock price of 37.5, a price located directly between the two strikes, (using our example of the August 35 – 40 call spread) we can see the approximate value of the spread is roughly $2.5 dollars. This is because the August 35 calls and the August 40 calls are equidistant from the current stock price of $37.50. Being equidistant from the stock, both the August 35 and 40 calls will have almost the same amount of extrinsic value in them. Thus, in the spread, the extrinsic values of the two options cancel themselves out since you are long one call and short the other. This would leave each option value consisting of only intrinsic value. With the stock at $37.50 the value of the August 35 – 40 call spread will be $2.50. The August 35 calls will have $2.50 in intrinsic value while the August 40 calls will have $0 in intrinsic value. The difference gives you a spread with a value of $2.50.

A general rule of thumb is: if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.

For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spreads value will increase toward its maximum value described by the difference between the two strikes.

For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.