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VERTICAL SPREADS

Why Vertical Spreads... Vertical Spreads are used to offset premium costs when buying options or to hedge risks when selling options. The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management. While verticals are often considered a more advanced options strategy, the strategy usually has lower risk and a better probability of profit than outright call or put buying.

Table of Contents What is a Vertical Spread?

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Example

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How they win and lose

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Wrap-up

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Options involve risk and are not suitable for all investors. Investors may obtain a copy of Characteristics and Risks of Standardized Options at www.888options.com or by calling trade MONSTER™ at 877-598-3190. This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OM Securities LLC. OM Securities LLC does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Option examples utilized assume standardized exchange-traded options without adjustments or other non-standard features and do not take into account all relevant costs, including commissions and interest charges. Copyright © 2008 OM Securities LLC dba trade MONSTER™. All rights reserved.


VERTICAL SPREADS

What is a Vertical Spread? Vertical spreads can be done with calls or puts. Implementing the strategy involves buying one option and selling another option of the same type and expiration, but a different strike. A long vertical call spread would entail buying one call and selling a higher strike call. This type of spread would be done for a debit. A bear call spread or short call vertical would entail selling the lower strike call and buying the higher strike call to hedge the risk. This is a bearish trade and produces a credit in your account. Cash will be held as a margin for the position. Long vertical spreads (call and put versions) profit from a directional move. For a full profit, the underlying needs to move beyond the sold strike by expiration. The position will be profitable if the stock has moved past the bought strike plus the debit paid. For example, if XYZ call vertical spread is purchased, buying the 25 call and selling the 30 call for a debit of $2, then the full profit will come with the underlying anywhere above 30, and the position will profit anywhere above 27. Call credit spreads will make a full profit if the underlying is below the sold strike at expiration. The break even is the strike plus the credit. Put credit spreads will profit if the underlying stays above the strike sold minus the credit. Example: Sell the XYZ 30 put; buy the XYZ 25 put to hedge the risk, for a credit of 2.50. The position will profit anywhere above 27.5, but will get a full profit if XYZ is anywhere above 30 at expiration. Vertical spreads lose if the underlying moves in the wrong direction. The maximum loss for debit spreads is the debit paid. The maximum loss for credit spreads is the difference between the two strikes used minus the credit (this is also the amount of cash held in your brokerage account as a margin set-aside). Debit vertical spreads are used to offset the premium cost of the purchased option, especially when volatilities are high. Credit spreads are used when one wants to be a seller of options, but wants to limit the risk.

Options involve risk and are not suitable for all investors. Investors may obtain a copy of Characteristics and Risks of Standardized Options at www.888options.com or by calling trade MONSTER™ at 877-598-3190. This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OM Securities LLC. OM Securities LLC does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Option examples utilized assume standardized exchange-traded options without adjustments or other non-standard features and do not take into account all relevant costs, including commissions and interest charges. Copyright © 2008 OM Securities LLC dba trade MONSTER™. All rights reserved.

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VERTICAL SPREADS

Example The risk profile of a bull call debit spread or long vertical call spread is shown below. With the stock at 149, the 150 call is purchased for $10, and to offset some of that cost, the 160 call is sold for 5.90, for a net debit of $4.10

Shown below is what the risk profile looks like at expiration. The position profits at any price above $154.10, but the gain is capped if the stock moves beyond 160.

Options involve risk and are not suitable for all investors. Investors may obtain a copy of Characteristics and Risks of Standardized Options at www.888options.com or by calling trade MONSTER™ at 877-598-3190. This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OM Securities LLC. OM Securities LLC does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Option examples utilized assume standardized exchange-traded options without adjustments or other non-standard features and do not take into account all relevant costs, including commissions and interest charges. Copyright © 2008 OM Securities LLC dba trade MONSTER™. All rights reserved.

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VERTICAL SPREADS

How They Win and Lose Let’s take a look at an example of a winning position. XYZ price bounces off resistance at the same time that volatility spikes. Since volatility is high we will choose to buy call spreads as opposed to long calls, since the sold option in the spread helps offset the high option premiums.

With the stock at 23.50 and rising in mid-August, we will buy the September 22.50 calls for $2.00 and sell the 25 calls for $.85 for a net debit of $1.15. The maximum risk is the $115 we paid, realized if the stock is below 22.50. The maximum gain is $135. In this case, XYZ went up to 26, so the trade worked out perfectly, giving us a 117% return.

Options involve risk and are not suitable for all investors. Investors may obtain a copy of Characteristics and Risks of Standardized Options at www.888options.com or by calling trade MONSTER™ at 877-598-3190. This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OM Securities LLC. OM Securities LLC does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Option examples utilized assume standardized exchange-traded options without adjustments or other non-standard features and do not take into account all relevant costs, including commissions and interest charges. Copyright © 2008 OM Securities LLC dba trade MONSTER™. All rights reserved.

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VERTICAL SPREADS Let’s take a look at an example of a losing position. This set-up looks very similar when the trade was put on.

Again, we seem to have the price bottoming out, here in late July with a spike in volatility. The price breaks back above 48 as the volatility starts to fall, so we buy the August 49 call for $.80 and sell the 50 call for $.50 for a net debit of $.30. After a quick move in our direction, the price dives down to below 46. We hold the position and at expiration, we lose the debit we paid of $30 Impact of Stock Direction This is a directional trade, so the long call spread and short put spread will profit from the stock moving up and lose from the stock moving down. The maximum gain and risk are known from the outset of the trade and therefore allow for very specific risk management. Impact of Volatility The spread is used to limit exposure to volatility, so changes in volatility will have little effect. Impact of Time Decay Time is against you with a debit spread and for you with a credit spread.

Options involve risk and are not suitable for all investors. Investors may obtain a copy of Characteristics and Risks of Standardized Options at www.888options.com or by calling trade MONSTER™ at 877-598-3190. This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OM Securities LLC. OM Securities LLC does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Option examples utilized assume standardized exchange-traded options without adjustments or other non-standard features and do not take into account all relevant costs, including commissions and interest charges. Copyright © 2008 OM Securities LLC dba trade MONSTER™. All rights reserved.

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VERTICAL SPREADS

Wrap-up Vertical spreads provide known and fixed maximum gain and loss They are usually used when volatility and/or premiums are high They can be credit or debit spreads They can increase the probability of profit with directional trades, but limit the upside

Options involve risk and are not suitable for all investors. Investors may obtain a copy of Characteristics and Risks of Standardized Options at www.888options.com or by calling trade MONSTER™ at 877-598-3190. This material is being provided to you for educational purposes only. This information neither is, nor should be construed, as an offer, or a solicitation of an offer, to buy or sell securities by OM Securities LLC. OM Securities LLC does not offer or provide any investment advice or opinion regarding the nature, potential, value, suitability or profitability of any particular investment or investment strategy, and you shall be fully responsible for any investment decisions you make, and such decisions will be based solely on your evaluation of your financial circumstances, investment objectives, risk tolerance, and liquidity needs. Option examples utilized assume standardized exchange-traded options without adjustments or other non-standard features and do not take into account all relevant costs, including commissions and interest charges. Copyright © 2008 OM Securities LLC dba trade MONSTER™. All rights reserved.

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Why Vertical Spreads... Vertical Spreads are used to offset premium costs when buying options or to hedge risks when selling options. The ma...

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