This is a common question, with a simple answer. Trading Options Spreads are great, because the return on risk is much higher than selling naked Options.
Let’s say you’re trading XYZ (Everyone’s favorite Stock, right?)
You want to trade a simple Vertical Spread. Let’s say you’re bullish in both of the next two examples. Here’s what happens if you sell a Vertical, or if you buy a Vertical:
Selling a Vertical
If you’re selling a $50 Strike, and buying the $48 Strike for a total Credit of $0.50:
- Your maximum risk is the width of the Strikes, minus the Credit received.
- $50 – $48 – $.050 = $1.50
- Your maximum profit is $0.50 (Multiplied by 100 shares is $50)
- Your Return On Capital is 33.3%
- $0.50/$1.50 = 33.3%
A 33.3% Return on Capital isn’t too shabby.
Buying a Vertical
If you’re buying the $50 Strike, and selling the $52 Strike for a total Debit paid of $0.60:
- Your maximum risk is the Debit paid.
- Your maximum profit is the width of the Strikes, minus the Debit paid.
- $52 – $50 – $0.60 = $1.40
- Your Return On Capital is 30%
- $0.60/$1.40 = 42.8%
Again, the Return on Risk here is pretty good.
Different Factors Will Affect The Trade’s Outcome
A multitude of factors go into the trade’s actual outcome, such as:
- The Debit paid, or Credit Received
- The width of the Strikes
- Your Delta numbers on the Short Strike
- The Liquidity of the particular Options you’re trading
- How much you’re collecting in Credit, or paying in Debit to cover the costs of the naturally occurring of losing trades
Delta Is More Important Than Theta Here
Your Delta numbers are what decides the probability of success in Options strategies– not Theta.
While Theta is an important concept that we can profit on, it is not important to know the exact Theta numbers of the trade upon execution. Theta will naturally work its magic, but again it’s not important to know the exact Theta number for trade execution criteria.
The Secret Sauce
The secret to trading Options Spreads successfully, is to trade small. Make sure that you’re not trading too much size relative to your account size. Mathematically speaking, the probability of success, matched with the number of occurrences and with how much you’re collecting in Credit, or paying in Debit, is what decides the actual profitability of these trades at the end of the day.