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:
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.