Defined Risk Strategy

With Defined Risk Strategy you use several combinations of stock options to make profit where you’re the risk is limited. Defined Risk strategies are known as vertical spreads. Traders can choose from many strategies available to set up a trade. You can enter a trade by simply buying or selling a position and taking more risk, or you may employ one of many options strategies available, depending on how much risk you want to take.

Most starting traders are buying calls when they have a long bias. In the other case when they think the price of on option will drop they buy a put.  In fact, most option trades are made with naked calls or puts.

Although there are many strike prices most traders choose an option with a strike price close to the stock price. And because they don’t want to pay much they often choose an option that expires the next month. Naked options can be expensive an you can take on a lot of risk. We want to reduce it therefore we may choose defined risk strategies or vertical spreads.

 

Defined Risk Strategy

In this article we explain the use of vertical spreads for entering option trades with defined risk strategy. We are looking at the advantages of vertical spreads offer over naked options.  Vertical spreads offer a unique ability to control risk and reward by allowing us to determine our maximum gain, maximum loss, break-even price, maximum return on capital, and even the odds of having a winning trade, all at the time we open the position!

First, let’s go over the basics of vertical spreads. Remember that a single call option allows the buyer to control 100 shares of an underlying stock (or ETF  or ETN)  The current price of a stock option is known as the option premium, and is quoted as the dollar amount per share.  Stock option premium have two components.  The intrinsic value is the amount by which the option is in-the-money: stock price minus strike price for a call option, and strike price minus stock price for a put option.  In addition, there is the extrinsic value which represents the value represented by the time remaining until expiration.  The extrinsic value decays to zero by expiration, where only intrinsic value remains.

You can make vertical spread with using either call options or put options. It is created by buying an call option and selling another call option from the same stock and expiration date, but with different strike prices. Entering these vertical spreads can be done for either a net debit or a net credit.  When you get a credit of need to pay a debit depends on which option has the higher price.  For vertical call spreads, the call option with the lower strike price has the higher premium, and for vertical put spreads, the put option with the higher strike price has the higher premium.

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A defined risk strategy or vertical call spread is constructed using two call options.  If we are moderately bullish on a stock, we can construct a call spread by purchasing a call option with one strike in the money, and one strike out-of-the-money and sell a call option with a higher strike price. This type of vertical spread is known as a bull call spread. Your are anticipating of a rise op the option price. This is a bullish position. You seek to make a profit because the value of the position goes up as the price of the stock goes up.  This type of vertical spread is also known as a debit spread. Typically you have to pay a debit to enter this trade, because the premium of the long call is higher than the premium of the short call.  The described options are simple option strategies with defined risk. There are also more advanced option strategies. You can also make money with credit when you sell option premium.

Defined Risk Strategies can be created on the call side, or on the put side or on both the call and put side together. These defined risk strategies are called Iron Condors or butterflies.

 

Defined risk strategy maximum Risk

The maximum risk you have when using defined risk strategies is the width of the strikes minus the credit you received. The maximum risk for a credit spread is the debit you paid for the call spread.

 

Other defined risk strategies

Define option strategies can be simple playing on one side and expiration month. You can also create more advanced option strategies with defined risk strategies using stock options combinations with different expiration date. These defined risk strategies are called diagonals or calendars. You can create it at the call side, put side or on both together.

 

If you enjoyed this article you can read more on when to trade vertical spreads.