Market Insights

It’s the most important week in earnings season. Now’s a great time to review one of the most important options strategies — the vertical spread.

Our previous post covered how to profit from stocks going nowhere after a big event. This one considers just the opposite: how to position for a big move with limited risk?

The answer is by purchasing one option near the money and selling another strike further away. You pay a debit up front, with the potential to earn much more later. Bullish or bearish, the vertical spread is one of the most simple and effective options strategies.

Take Apple (AAPL), which reports Thursday afternoon. Say you expect the iPhone maker to rally on strong numbers. You could have bought shares for $283 yesterday, and jeopardize a ton of capital. What if the millions of job lost to coronavirus hurt iPhone demand? What if the lockdowns disrupted Asian factories and handset production?

Traders can mitigate some of those unknowns with a vertical spread.

Bullish Vertical Spread

Here’s how someone might get long AAPL with much less capital at risk:

• Buy the 1-May 290 calls for $3.80.
• Sell the 1-May 300 calls for $1.15.
• That results in cost of $2.65.

Owning calls fix the price where a stock can be purchased, while selling them creates the obligation to deliver shares if they pass a certain level. Combining both in a spread programs the entry and exit, potentially harnessing a move between the two prices.

In this case a trader would effectively own AAPL for $290 if it jumps above that level. If the stock keeps going above $300, they’d have a built-in sale from the short call. He or she would keep the $10 difference.

That’s a 277 percent profit, based on the $2.65 entry price. It also would require a move of barely 6 percent in the underlying stock.

When people say options generate leverage, this is what they’re talking about!

Bearish Vertical Spread

The exact same technique also works to the downside if you use puts. Say you’re negative on AAPL and see it falling toward $270. You could craft a bearish trade like this:

• Buy the 1-May 280 puts for $5.50
• Sell the 1-May 270 puts for $2.08
• That results in a cost of $3.42.

Owning puts fix the price where a stock can be sold. Shorting puts creates an obligation to buy if the shares fall to a certain level. Once again, the spread controls a move between two spots on the chart.

In this case, they’d collect $10 from AAPL closing at $270 or lower on expiration. It would represent a gain of 192 percent based on the $3.42 cost.

The beauty of the vertical spread is that it has limited volatility risk. Yes, AAPL options will lose extrinsic value quickly after the earnings report. But that hits both the long and short legs about equally. As a result, time decay is much less of a problem.

The main risk is getting the direction wrong. It only rewards traders who correctly anticipate which way the stock is going to move.

Big Earnings This Week

It may be a good time to learn the vertical with several major earnings reports in the near-term. Aside from the big technology names, other highly active underliers like General Electric (GE) and Boeing (BA) are scheduled for this week. Here’s a rundown of some important names:

Disclaimer: This article is for educational purposes only and shouldn’t be considered a trade recommendation. Trading options may not be suitable for all investors.