How Could Vertical Spreads Help Your Strategy?

Let's say you're short a single 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 gain. 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 was 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 status.

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 bullish vertical spread by buying a lower-strike put.

As mentioned above, since the requirements for selling a cash-secured put are 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 obligated to buy the stock if you're assigned) and zero. But with many stocks it can be a long way to zero.

Perhaps it's time to think vertically.

A put vertical spread is long one put option and short another put option at different strike prices 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 (a long put) that's further out of the money than the existing short put position.

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

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 bullish 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 maximum risk of a bullish put 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 (typically 100) for standard U.S. equities, as well as transaction costs.¹

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.
 

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 in cash to make up the $13,400 total.

If executed in a margin account, the new margin requirement for the bullish 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 bullish put vertical spread lowered your potential profit by $25, but reduced your requirement by roughly $12,890 (from $13,290 to $400).

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

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 also be cost-prohibitive even for those with margin accounts and naked options approval. Also, naked options trading involves substantially more risk.

A few things to keep in mind:

• Spread trading can only be done in a margin account
• Many account types do not qualify for margin
• Increased leverage significantly increases risk

So, the next time you're short a single-leg option and looking to potentially 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.