Selling vertical put option spreads: Defined risk and reward with a bullish bias

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Define your risk, but also limit your profit.

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If you have experience trading single option contracts, you may be ready to jump to the next level. Maybe you like the prospect of selling options and collecting premium, but can’t (or your broker won’t allow you to) accept the open-ended risk.

So what’s that next level? Selling vertical spreads.

This simply means you’re selling a put or call option for a credit and simultaneously purchasing a long put or call option of the same expiration date, but one that’s further out of the money.

So with a short vertical spread, you’ll:

To explore the vertical spread strategy, consider a stock that’s trading at $102 per share, with strikes and prices for an option series that’s expiring in 40 days.

Suppose the stock has been drifting down and you think it’s poised to either sit still for a while, or perhaps rally a bit. You could buy shares of the stock. If you’re an options trader, you could sell a cash-secured put. But each of those choices would leave you exposed to downside risk if the stock were to keep falling.

Another solution might be to sell an out-of-the-money put vertical spread. The “out-of-the-money” part means the strike prices are below where the market is currently trading. This is also known as a bull put spread or a short put vertical.

You might choose to sell a 95-strike put at $3.35 and buy a 90-strike put at $1.95. In trader lingo, you’d “short the 90/95 put vertical” for a total credit of ($3.35 – $1.95) = $1.40. Because each option contract controls 100 shares of the underlying stock, your initial credit would be $140.

Note: Most trading platforms will allow you to enter the spread in a single order ticket.

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SHORT PUT VERTICAL: RISK PROFILE AT EXPIRATION. Above the high strike, you pocket the premium. Below the low strike, you lose the max. The area of uncertainty lies between.

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Vertical spreads are a flexible way to customize your risk and reward. There’s a high probability of making a profit, which is an attractive feature of out-of-the-money put or call vertical spreads. In other words, the odds are in your favor. Don’t get too excited, though—the risk/reward metrics are often unattractive for this type of spread. That’s the trade-off.

Once executed, there are five possible outcomes for the put vertical:

Among those five outcomes, you win in three of them (and potentially four). That’s a pretty good percentage, right? The trouble is—and it’s something you’ll see time and time again with options—the risk/reward is typically commensurate with the underlying probabilities. In other words, the more likely an option is to be profitable, the lower its payoff relative to the amount you could lose.

In this example, the odds of a profit are pretty favorable. But the most you could lose with this spread, $360, is more than twice your maximum profit of $140. And if you employ this strategy often, each time one of your spreads hits the max loss, it will erase the gains on several of your previous winning vertical spreads.

Risk management is always a key consideration.

Let’s calculate the breakeven on a short vertical put spread. The math is fairly straightforward: Simply take the width of your long and short strikes and subtract the credit you collected. For example:

Now that you know your breakeven and max risk, you may ask: Is it necessary to hold the credit spread all the way until expiration? The short answer is no. You can close out a position at any time. Veteran option traders know this and use it to their advantage.

With our short put vertical example, if the underlying stock were to rise fairly quickly, you might only need to be in the trade for a few days to realize a profit on the majority of the credit you collected. In that case, it may make sense to close the trade down early at the current profit level and deploy your capital elsewhere.

Many traders close their trades once a certain percentage of the original credit collected has been realized as profit, say, 50% or 90%. This is really up to your discretion as a trader and how your strategy fits in with your risk management rules.

Short vertical spreads are a popular defined-risk and defined-profit strategy. If your directional bias is to the upside, selling a put vertical could even become a go-to strategy choice. If you focus on out-of-the-money strikes, the odds of finishing with a profitable trade are on your side, but as noted above, the maximum loss is much greater than the maximum profit.

One way to control the risk is active management. If you know your profit and loss targets, you can time your entries and exits to your maximum relative advantage.

The ability to select your time frame and the strike prices that define your spread makes short vertical spreads a flexible strategy that you can match to your account size, time horizon, and risk tolerance. But if you’re just beginning, start small and keep your risks well defined and under close watch.