How Can I Exit A Vertical Option Spread Without Getting Creamed?

Pretty normal question to ask. You have a vertical option spread that you need to exit but you don't want to get creamed getting out of the position.

Even for the most experienced traders this can be a tricky path to walk. So in this article, I'll try to help explain how you can safely look for the exit doors without seeing your profits evaporate.

Let's Start At The Beginning

First we need to quickly talk about the Vertical Option Spread. And for simplicity we are only going to cover Debit Spreads in this article. For this trading strategy you make a simultaneous purchase and sale of two options of the same type (Call/Put) that have the same expiration dates but different strike prices.

Depending on your market bias, you could create a Bullish Spread or a Bearish Spread - both with either Puts/Calls. As you now options are very flexible. Let's use this simple example for our purposes:

Bullish 150/160 Vertical Call Spread

In this example we are assuming you BUY a Call with a strike price of $150 for $100 and at the same time SELL a Call with a strike price of $160 for $70 = a net debit (or cost) of $30 per spread.

Naturally the $150 Call is closer to the money than the $160 Call and costs more, so you are using the proceeds from the short $160 Call to help pay for the long $150 Call.

The overall goal of a trade like this is that the market will continue higher past $160 by expiration at which point your $30 investment turns into a great profit. However, as well all know, when you try to predict the market direction things can and will go wrong from time to time.

The Trade Goes Wrong - Now What?

For one reason or another things don't go your way right? Either the stock didn't go higher or it made a late move and now expiration and time decay are eating away at the premiums. Whatever the case, there are a number of ways to manage bad trades in a market like this. Here are my "preferred methods."

Each depends on market conditions so keep them all handy and use the one that fits best for your trades.

1) Scaling Or Legging Out

Scaling out of the position on strength is my favorite technique. If the stock continues to rally but you know it will never hit your target, then buy back the short $160 Call early and take advantage of any upside move with the $150 Call.

If the move stalls and starts trading sideways or heading lower then do the opposite. Buy the $150 Call and savor whatever premium you can get while leaving the short $160 open. Here you will take advantage of the remaining time decay of the short call.

2) Set Trailing Stop Loss Orders

For the beginner trader this will probably work best as it's very easy to use and understand. Legging into and out of trades can become very complex and may require some additional trading experience. But stops are always great tools for any trader and have saved me multiple times.

What you would do is set a trailing stop loss order just below the market price. So let's say the spread is now worth $20 (instead of the $30 when you bought it). You could set a $10 trailing stop loss order meaning that if the spread increases in value then the stop order moves up and keeps locking in your profit. If market turns around quickly then it will get you out of the trade at $10 and savior what could have been a 100% loss on the trade.

3) Reverse The Trade Completely

I typically don't favor this strategy because you are "giving up" on the trade completely. When you reverse the trade you are going to be selling the $150 Call and buying back the $160 Call. Whatever you get for the option premiums is what you get.

I have left this for the last option because when you reverse the trade you are not leaving any possibility for stretching the trade and making the most of a bad position. Over the years it's the traders who find an extra $5 or $10 here and there in bad trades that end up making more money. Even bad trades can still turn around and lose LESS than you expect if you were to close out the trade completely.

What Am I Missing Here?

There are multiple ways to enter and exit trades depending on the market you are trading in. So what has worked for you in the past that you can suggest to everyone else? Add your comments here if you have questions or want to suggest another angle for exiting vertical option spreads.

  • gregdgreek@msn.com

    Hi Kirk,

    You got the selling part wrong. This is a Bull Vertical call spread so both legs should be calls.
    We would want to sell a call, not sell a put.

    On another note I would like to know you handle stop losses and exit trades on credit spreads when the trade is going against you.

    Thanks.

    Greg

    • Kirk - Admin

      Thanks for catching that for me Greg - minor type on the Put vs. Call but it makes a difference :)

      If your question is "how I handle stop losses and exit trades" then I prever to leg out of the trade if at all possible. Stop losses are great only when I already have a fat profit on the trade. If it goes against me from the start then stop losses only lock in a bigger loss. I'd rather leg out of the trade and try to save some money that way.

      Hope this helps and again thanks for the comment!

  • Kirk - Admin

    Unemployment rate drops to 8.9% but Oil is now trading above $103.50...thoughts???

  • kuching1000

    test

    • Kirk - Admin

      Yep you can post there kuching 1000

  • kuching1000

    Frankly, I don't believe the government statistics on the unemployment rate. They are grossly understated,and subject to revisions later. However, it does seem that the employment picture is improving today. Sustained oil prices over $100/bbl certainly will put a damper on any nascent recovery. Watch out below.

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  • Tom

    I have been selling puts and calls rolling up or down if I am wrong .

  • Bryson

    How much room is needed for a spread to be attractive, 50%, 60% etc.... compared to the debit paid for the spread?

    • http://optionalpha.com/ Kirk Du Plessis

      Bryson - do you mean 50%, 60% probability of being OTM? Are you talking about buying a spread outright?

      • Bryson

        What I meant is this, say your looking to enter a 10 point debit spread, how much of the spread would you require to be left after initial debit to be attractive?

      • http://optionalpha.com/ Kirk Du Plessis

        That would depend on your underlying assumption and probability requirement. Say you enter a 10 point wide spread for 5.00 = this would mean you have a 50/50 shot of making 5.00. If you enter a spread at 3.00 you have a 30% chance of making money. Really there is no right or wrong answer here. I would suggest any debits are 50/50 and any credit spreads are at 70% probability of success or better.

  • Bill

    I am assuming here that for example say you open the RUT at 930/940 call short side being 930. If RUT price goes to 940 time to cut?

    • http://optionalpha.com/ Kirk Du Plessis

      No not necessarily to wait that long but rather to exit earlier or hedge with another long call.

      • Bill

        So you talking about opening another spread say 940/950 as hedge?

      • http://optionalpha.com/ Kirk Du Plessis

        Nope. It would be something like buying a 945 call and creating a ratio spread that would profit should the market continue higher.

  • justin

    When you refer to legging out, don't you mean selling the 150 call while remaining short the 160 call, when you say "If the move stalls and starts trading sideways or heading lower then do the opposite. Buy the $150 Call and savor whatever premium you can get while leaving the short $160 open. Here you will take advantage of the remaining time decay of the short call."

    • http://optionalpha.com/ Kirk Du Plessis

      Yes you're right (typo on my part) you would sell the long 150 call you already own and keep the 160 call short still

  • http://optionalpha.com/ Kirk Du Plessis

    Because if you buy the short call back you profit on that side of the trade and you can leave the long call which will expire worthless as a lottery ticket in case the stock rallies.