Vertical Spread Strategies

You can use spreads to exploit time value premium. These changes are predictable because everyone knows what happens to time value as expiration approaches. And when options are in the money, it is reasonable to expect intrinsic value premium to react dollar for dollar with movement in the price of the underlying stock. Time value premium can change in predictable ways, which presents opportunities for short-term profits. The relationship between intrinsic value and time value is what makes the spread an interesting and challenging strategic tool.

Smart Investor Tip

As with most option strategies, time value spells the difference between profit and loss in most spreads.

You have an advantage when offsetting long and short positions.
The spread employing short-term options is likely to involve one side in the money and the other side out of the money. The in-the-money side will tend to change in value at a different rate from the out-of-the-money side, because it contains intrinsic value. By observing the differences on either side of the striking price, you can anticipate advantages that you can gain through the spread strategy, whether the market moves up or down.

Whenever you combine a long call with a higher-strike short call, you create an alternative form of "cover" for the short position. The risk disappears as long as both positions are open because, even with a large price run-up in the stock, the long position is always going to be worth more than the short position. This remains a covered position as long as the long position is open. However, if the long call expires and the short call remains open, it reverts to an uncovered position. So the safest covered spread of this type exists when both expire at the same time (or when the long position will be open longer than the short).

It is also possible to create a covered put using the same strategy. It involves creating a spread in which the long position has a higher strike than the short put position. If the stock's value falls so that the short put is in the money, the long put will also be in the money and will always be worth more. This is true as long as both puts expire at the same time, or when the long put remains open longer than the short put. This is the only situation in which a short put can be truly covered. In "Selling Puts: The Overlooked Strategy", the many strategies involved with the selling of puts demonstrated why puts cannot be covered in the same manner as calls; but in a put-based spread, you can overcome this limitation and create a low-risk strategy.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2016. Content published with author's permission.

Posted in ...