Study Notes:
Let’s assume that you believe shares in Apple (Symbol: AAPL) might decline from the current share price of $160 over the next 30-days. And even if they did move up, it would only be a little higher. In this lesson we’ll discuss how an investor could potentially make money using options from this view.
A 30-day call option at the 170 strike is priced at 3.25. And the 180 strike call option is priced at 1.00. The investor might sell the lower 170 strike and receive $325, and pay $100 to purchase the 180 strike.
Why spend the $100 to buy the 180 call if we believe that the stock going over even 170 is very unlikely?
Because it limits your exposure from potentially infinite losses, no matter how unlikely they seem.
Since the investor is receiving more for the lower strike call than they are paying for the higher strike, the net cost of combining the two strike prices is a credit of $225. The combination in this order is called a vertical credit spread.
Because the investor does not believe the share price will go much higher, they are taking advantage of the difference in premiums on both call options since they expect them to be worthless at expiration. If, as the investor expects, the share price of AAPL falls, they keep the entire premium from the vertical credit spread. In fact, so long as shares in AAPL remain below 170 at expiration, the investor keeps the whole $225.
The initial credit received on the trade raises the breakeven point on the transaction by the amount of the 2.25 credit. Add that to the lower strike price of 170 to calculate a breakeven price of $172.25.
The investor will face rising losses penny-for-penny above this point in the event the share price continues to rise. The distance between the higher and lower strike prices is $10, and since each option contract represents 100 shares, that’s worth $1,000.
Since the investor received $225 to make the trade, the maximum loss the investor could face is $775 and would occur at the upper strike price. The long call at the higher 180 strike price will equally and exactly offset losses from the lower 170 strike no matter how high the stock price goes.
The vertical credit spread is a commonly used strategy with option traders who expect prices to stall or even fall over the lifetime of the option contract.
Disclosure: Interactive Brokers
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Disclosure: Multiple Leg Strategies
Multiple leg strategies, including spreads and straddles, will incur multiple commission charges.
