How Could Vertical Spreads Help Your Strategy?

Let’s say you’re short a single-leg put option, and the market has been chopping along, maybe grinding higher. Unless implied volatility has been steadily climbing, you’re probably sitting on an unrealized profit. Getting nervous about whether your good fortune might continue?

Unless you have approval to trade uncovered (“naked”) options (more on that in a bit), your short put requirement is about the same as buying the stock outright, only with the short put, you aren’t entitled to any dividends that might be paid, and you have no voting rights. However, you still need to have enough capital in your account to cover the purchase of the stock, in case you get assigned (this is called a “cash-secured” put). And remember, a short equity option can be assigned at any time up until expiration, regardless of the in-the-money amount. 

Looking for a way to reduce downside risk in your current position without giving up too much of your potential profit? If you have a margin account approved for spread trading (Level 2 at Schwab), there’s a way.

The strategy: Turn it into a vertical spread by buying a lower-strike put.

As mentioned above, since the requirements for selling a cash-secured put is about the same as buying the stock outright, it can be quite capital intensive. The requirement equals the risk; which is the difference between the strike price (the price at which you’d be required to buy the stock if you’re assigned) and zero. But with most stocks, and particularly with the many high-priced stocks popular with investors these days, it can be a long way to zero.

Perhaps it’s time to think vertically.

Short option into a vertical spread? Take a leg

A put vertical spread is long one put option and short another put option at a different strike price in the same underlying asset, with the same expiration date. Usually both legs of a vertical spread are established simultaneously, but you can create the same position by buying an option that’s further out of the money than the existing short option position.

First, let’s look at a graphical illustration of two risk profiles—the cash-secured put and the short put vertical spread—followed by an example with numbers.

Figure 1: Risk profile of a short put and a short put vertical spread

Note that buying a lower-strike put turns a short single-leg put into a lower-risk spread. For illustrative purposes only.

Let’s say a week ago you sold a 134-strike put option for $1.10, and now it’s trading at $0.83. The position has been working in your favor, but you’d like to reduce your risk and lower the margin requirement without closing the position.

In this case, you could buy the 130-strike put for $0.25, which would create a 134/130 short put vertical spread, for a combined net credit of $0.85. That’s calculated by taking the original $1.10 premium you received a week ago, minus the $0.25 premium you just paid for the 130 put. The net risk of a short vertical spread is the difference between the two strikes minus the net premium—$4 minus $0.85, or $3.15. And remember to include the multiplier for standard U.S. equities as well as transaction costs.

In summary: ((134-130) - ($1.10 - $0.25)) x 100 = $315 (plus transaction costs) in risk and a potential profit of $85 (minus transaction costs) vs. a potential profit of $110 in the original trade.

Remember the kicker: Requirement reduction

The initial requirement for selling a single 134-strike cash-secured put is its strike price, times the multiplier, or ($134 x 100) = $13,400. After the order is executed, the $110 credit received can be combined with $13,290 to make up the $13,400 total.

If done in a margin account, the new margin requirement for the short 134/130 put vertical spread is the difference between the strikes x $100, or: (134-130) x $100 = $400.

In this example, while the assignment risk of the short leg remains the same, turning the cash-secured put into a put vertical spread lowered your potential profit by $25, but reduced your requirement by roughly $12,890.

Margin and Levels of Options Approval

Without naked options approval (Level 3 at Schwab) in a margin account, you can’t sell naked puts, and instead can sell puts that are cash secured, which, as you can see from the above example, is capital intensive. By the way, selling cash-secured puts requires Schwab Level 0 options approval or higher.  

Bottom Line on Selling Single-Leg vs. Vertical Spreads

Capital preservation and capital efficiency are two cornerstones of options trading. By vastly reducing a margin requirement through the use of a vertical spread, you can free up funds for another trading opportunity. The intensive capital requirements associated with selling naked options can even be cost-prohibitive for those with margin accounts and naked options approval, and naked option trading involves substantially more risk.

Note: It’s important to remember that spread trading can only be done in a margin account, many account types do not qualify for margin, and that increased leverage significantly increases risk.

So, the next time you’re short a single-leg option and are looking to reduce your risk, consider turning that short option into a lower-risk vertical spread - and you’ll even free up some trading capital in the process.