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BookingAlpha Option Trading Advisory

Tuesday, March 20, 2012

Locking profits on a Vertical Spread

Let's say you trade a vertical spread on XYZ instrument. XYZ is trading at 100 and you place a Bull bet, you buy a 105 Call for 0.75 and sell a 107 Call for 0.50. All that for a net debit of 0.25 and a max return of 1.75 (2 point wide spread - 0.25 risk = 1.75 max reward)

BUY  1 Strike 105 CALL @0.75
SELL 1 Strike 107 CALL @0.50

If by expiration, price is below 105.25 there is a loss which is at most 0.25 ($25 per contract). Anything above 105.25 means a winner with a maximum profit of 1.75 ($175 per contract)

The trade moves in your favor quickly. XYZ is now trading at 104. The 105 Call is trading at 2.00 while the 107 Call is priced at 1.20.

Strike 105 CALL @2.00 (From 0.75 to 2.00 that is a 1.25 profit)
Strike 107 CALL @1.25 (From 0.50 to 1.25 that is a loss of 0.75 as I am short this contract)

Overall there is a 1.25 profit in the 105 CALL which I am long, and a 0.75 loss in the 107 CALL, which I'm shorting. That's an overall profit of 0.50 which is temporary. If XYZ were to stay at 104 by expiration I would lose that profit in time decay. The profit can also be lost if the stock pulls back.

You want to keep that profit but also stay in the game for potentially more.
Well here's the trick: You  open a Vertical Spread against your initial bias!

For example assuming the 109 CALL is priced at 0.80 and the 111 CALL at 0.20, you can Open a Bear Call Spread selling the 109 and buying the 111 for a Credit of 0.60.

SELL  1 Strike 109 CALL @0.80
BUY  1 Strike 111 CALL @0.20

By opening a Call Credit spread for a Credit (0.60) greater than the initial debit invested on the first Debit Bull spread (0.25), there is a locked in profit in the trade. In other ways, this trade cannot be a loser anymore, and there is a minimum guaranteed profit of 0.35 (0.60 - 0.25). The resulting profit picture combining everything looks like this:

There is now a guaranteed profit of 0.35, plus the potential maximum return went up 0.60 from 1.75 to 2.35. From then on it is all a waiting game. True, your temporary profit of 0.50 is now reduced to 0.35 but this one is guaranteed plus the possibility to make much more as your maximum return.

As usual this technique is also applicable with Puts.
Usando box spread Usando Three Legged Box Usando un vertical del otro lado ya una vez mas barato por profit del inicial

Related Articles:
How to lock in profits on an options trade and stay in the position
Locking profits with the Box Spread 
The Three Legged Box explained

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  1. Good post. Why did you choose the 109 - 111 spread as your adjustment as opposed to say 107 - 109, 108- 110 etc.?

    1. Thanks for your question.
      This was a hypothetical example. XYZ is not a real symbol. The goal of the article was to explain the concept.