This article explores the viability of trading cheap vertical spreads for a living. We'll examine what these spreads are, their pros and cons, and how to potentially make them more profitable.
What are Cheap Vertical Spreads?
Vertical spreads involve buying and selling options of the same type (calls or puts) with different strike prices, but the same expiration date. They can be either debit spreads, where you pay upfront, or credit spreads, where you receive a credit upfront. Cheap vertical spreads typically refer to out-of-the-money debit spreads, often far out-of-the-money.
Call Debit Spreads (Bull Call Spreads)
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Involve buying an out-of-the-money long call and selling a further out-of-the-money call option.
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Profitable if the underlying asset's price increases.
Put Debit Spreads (Bear Put Spreads)
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Involve buying an out-of-the-money long put and selling a further out-of-the-money short put.
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Profitable if the underlying asset's price decreases.
These strategies are cheap because their cost represents your maximum risk on the trade. For example, a $5-wide call debit spread with a 20-delta strike price might cost around $80, offering a potential max profit of $400+, a risk-to-reward ratio of roughly 1:5.
Pros and Cons of Cheap Vertical Spreads
Understanding the pros and cons is crucial before employing any trading strategy.
Pros
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Low Capital Risk: You can construct these spreads very cheaply, sometimes for $50 or less by tightening the spread (reducing the difference between strike prices).
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Good Risk-to-Reward Ratio: As illustrated above, you can potentially achieve a 1:5 or even better risk-to-reward ratio by going further out of the money.
Cons
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Low Probability of Profit (POP) at Expiration/Low Win Rate: Out-of-the-money options have a lower probability of expiring in the money.
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Long Losing Streaks: A low win rate means a higher probability of experiencing consecutive losing trades, which can significantly impact trader psychology. For instance, a strategy with a 20-25% win rate has a near-certain chance of experiencing 10 losses in a row within a 100-trade sequence.
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Need to Be Right Quickly: You need to be right about the direction of the trade and see the price move quickly. Theta (time decay) works against you, especially as you approach expiration, eroding potential profits if the price doesn't move favorably in a timely manner.
Making Cheap Vertical Spreads More Viable
Despite the cons, there are ways to potentially improve the viability of this strategy:
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Go for a Longer DTE (Days to Expiration): Longer DTEs reduce the impact of theta decay, giving you more time for the trade to move in your favor.
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Exit at 50% Profit: Instead of holding to expiration, aim to close the trade when you reach 50% of the maximum profit potential. This significantly increases the win rate, as demonstrated by tastytrade's P50 metric.
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Use Overbought/Oversold Indicators: Employ indicators like the Stochastic Oscillator or RSI to identify potential entry points when the market is overbought (likely to decline) or oversold (likely to rise).
Conclusion
Whether trading cheap vertical spreads for a living is viable depends on your ability to accurately predict market direction and manage the inherent risks. By understanding the pros and cons and implementing strategies to mitigate the negative aspects, you can potentially increase the profitability of this strategy. Remember that being skillful at picking directions and applying risk management techniques are crucial.
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