Trading Vertical Spreads | Short Call Vertical Hedge | 6-19-19 | Cameron May
Hello. And welcome, everyone my name is Cameron May filling in for John McNichol once again, it, is Wednesday. Afternoon that means it's time to get back into our ongoing series, of discussions, called trading vertical, spreads and as you can see from the, title here we are going to be discussing hedging, using. Short call verticals so it's a bit of a follow up to last week's topic, if you need to go back and revisit that. Discussion, if you missed it that's, great you can go back and catch that on the archive, but. It's, always my pleasure it's, a privilege to be here with you today, I always, appreciate as, well you veterans, who returned week after week and contribute, to the discussion, thanks. For being here welcome, aboard and if. You happen to be for the very first time be here for the very first time I want to welcome you as well, we. Try to jam as much value as we can into our 45 minutes together but. Today we are going to be discussing about managing, risk on. A stock. Position, specifically. But using, an options strategy, so, we're gonna look at the pros and the cons of, using. A short call vertical now this may be a strategy maybe some of you haven't heard of use employing. As. As. A potential hedging strategy, I think, you'll see the logic of it it's not a sales pitch but just a discussion, an educational, experience, so hello there Michelle good to see you Ronald thanks for checking in already Robert. Good. To see you again, let's. First of all as we always do consider. The risks associated our investing some important information that we need to be aware of, options. Are not suitable for all investors spread. Straddles and other multi leg option strategies can entail substantial, transaction, costs all investing, involves, risks including risk of loss any to any investment, decision you make in your self-directed account is solely, your responsibility, there's. An overview of your Greek's for you we, are going to be using real examples. In today's discussion please, don't take that as a recommendation or, endorsement, of any, particular security, or strategy. And the usage of a stop order is not a guarantee that you'll buy or sell at a specific price, hello. There Remi good. To see you too alright, so. Class. We're gonna be teaching approaching. This at about an intermediate. Level if you need that if you feel like you need to take a step back and get back to options basics, you, may want to check out barb Armstrong, class on Friday mornings, that's. 11 o'clock Eastern Standard Time it's called getting started with, options, or. If, you, feel like you need to add some, more advanced, principles, to your understanding, of options, strategies, maybe you joined me for my Friday morning discussion, Ashley barb and I are. In. Consecutive. Slots. For, our, classes on Friday mornings my, class starts. At 7:30 Eastern Standard, Time and it's called managing, an options, portfolio, so I'd love to have you there but. Let's set an agenda for, today all, right let's. Go to the, thinkorswim platform where. I have three, points, that I'd like to cover with you today first, of all we want to introduce this concept of, hedging because sometimes we can throw out terminology, and assume that everybody in the audience knows what we're talking about most, of you do but I'm sure that there are some who've, heard of this but they don't know exactly how it might work or, what the implications, of the of that might be so. Once we understand what hedging, refers. To then, we're going to look at this potential, hedging strategy, a short, call vertical and finally. To, cement, these concepts. As we're learning them we're, going to be using some real, actual, example. Traits weighing. The pros and the cons getting, into the numbers so. Hopefully by the accomplishment, of these three steps. When. You're. Trading in your paper. Money account the next time you see a stock starting, to turn on market conditions starting, to weaken a bit maybe. You have at least one more strategy that you could conceptually, go to for. The management of that portfolio all right so. With. That setting the stage let's. Get some context. Regarding this discussion, everybody, what's going on with the S&P right now if you followed that this morning let's. Pop over here to a chart of the S&P. We're. Gonna be using Apple as our example trade, for today but, let's see what's happening with the S&P and I'm gonna clear off some old drawings, let's just clear this whole drawing set and, you.
Can See that for the last couple of weeks we've, been in recovery mode stair-stepping, higher highs and higher lows, however. What. It. Appears, to be from a technical vantage point on the immediate horizon. And maybe what I'll do is use my little rectangle, tool here to, draw an area. Rather than a specific line, right. Up in this range. Somewhere. Around there, you'll, notice that back in September, the. Market hit a peak a couple of times with the S&P did and then. Pulled back and. We hit a peak again in May. As we. Approach those same levels for the SP that was around that, 2950. Mark and, then. The S&P pulled back. Now. It, looks like we're approaching that again, following, a two or a three week run, up, so. There may be certain market conditions, so let's take this technical, point, of view let's. Suppose that, the SP, and therefore most, stocks. Have. Been upward. Trending, but. Maybe approaching. A price, ceiling or an area of resistance and. Let's just suppose at our technical expectation. Is maybe that we you know we go up here into that range we bump our heads and we come down for a little while now, am, I am i setting the expectation. That we're expecting a market collapse no this is just an exercise it's an educational, experience but I, am trying. To set the stage for this discussion, because these scenarios happen, from time to time where. You're bullish on the markets and yet, there are periods, where. A trader may come to the conclusion, that there's softness. At least in the short term ahead okay. So. That's what we're gonna go. Forward with for, this discussion, now let. Me ask you a question let's throw out a question here if you wouldn't mind chatting, in your answers, employing. Options. In a stock portfolio. What. Are some strategies that you can immediately think of that, may reduce the, downside. Risk, of a stock or a stock portfolio at. Least in the short term what. Do you think. I'll. Let you chat those in. I'll. Keep an eye on the chats but obviously there's a little bit of a delay as you answer your questions through YouTube and then it comes through to me as the presenter so, I'll start to outline some of these so. If. A trader is looking, to reduce, risk. On let's, say a stock, they. Could conceptually buy a put, on the stock and maybe that would be a good discussion for another for, a future. Presentation, but. What is about what does mine put a buying, a put allow you to do well it, gives you the contractual, right to sell. Shares of that, security. For. A fixed, price for a fixed period of time you. Know so let's switch over our. Technical, view from us from, the broad markets, to a specific, stock let's, look at Apple and let's just assume. Let's. Just make the let's. Make the assumption that maybe we think Apple, is likely, to follow the lead of the S&P or maybe even more closely than Nasdaq, right but. Let's just suppose that we think that Apple is likely to come down well. With, Apple trading around, $200. A trader. Could theoretically, go. Buy a put contract, for. However long 30 days 50 days 90 days however long you. Choose, to buy whatever, is available and. For. That period of time you have the contractual. Right to sell. Your shares at that, price so let's, say that we bought you know since we're trading just a little bit above 185, what if we said what if we purchased. A put at. 195. We then have the right for the duration of that put contract, to. Sell shares for 195, now. Here's my next question okay. And look yeah do, wait actually I'm going to come back to Duane, Michele.
Ronald. Each. One of you you've all answered the same question, just phrasing it a little bit differently yeah, that, answer is going to be important for today's discussion because, I'm going to tie back to it I'm. Going to use that to, set the foundation for building this short put vertical very, good but what they proposed Wayne Michelle and Ronald was selling. A call, alright. Well. So, an option trader could conceivably, buy. Options, to reduce risk sell. Options to reduce risk with, both of those. There. Are potential, advantages, and potential. Disadvantages. What's. One, of the. Potential. Disadvantages, inherent. To. The purchase, of a put option. Okay. When. You buy a put, obviously. You're, spending, some money yes so it comes at a cost. Now. That. Cost. Does. Accomplish, something for you it, gives you that contractual, right to sell shares at a fixed price. However. It. Also. It. May turn out that you may not need, that put, protection. In. The days and the weeks to come if the stock continues to rally that, put can actually place, a drag, on the performance. Of that stock. Now, if the stock rallies far enough eventually, the. Put drag. Loses, its potency and the stock can just continue to climb a stock has. Unlimited, reward. Potential, owning. A put has a limited, cost right, so there's limited, risk there versus. An unlimited reward, potential, so yeah there's a there's a bit of a trade-off that we need to be Ora will, dive deeper into that into a few in a future discussion but I want to go to. Dwayne. Michelle, and Ronald's. Proposal. Here sell. A call and Ricardo, has a number one then Ricardo. We. Got, into synthetics, in one of my classes, I can't remember one but I do I probably, owe you another more, detailed discussion so. You. Know what I actually brought my notepad, here. Because. Sometimes. Ideas come up in class that we need to explore I'm gonna make a note of that so. Short. Synthetics. What. We may do is, explore. That in my. Thursday. Class is called selecting, an option strategy, what we might talk about what sort of market conditions may lead a trader to, do something like that, all. Right so. Thank. You Ricardo I'm gonna put, a circle around that we'll, come back to it all. Right there's Chuck hello Chuck it is actually going really well I feel really refreshed for my recent trip to Outland my, wife is already champing. At the bit to get back to Scotland so I kind. Of suspect that, we're going to be pulling out our wallets and buying, some return tickets. Here before, too long I don't even know if we're gonna make it a year before we have to go back anyway, yeah, it was fantastic thanks for, asking Chuck anyway. So let's, get into. We. Now understand. Hedging. Is, when. When. An investor. Sees, potential. Short-term. Softness. In the markets or a short term threat to. Their portfolio it may be long term now. Let me ask you this if you, are. Long. Bullet. Or your your. Outlook. For the markets has been primarily. Bullish in it. Just as a point of example, and. Then. You see a long term shift, to, that outlook. What. Else might be done with a portfolio even setting. Options, aside obviously, there might start to be adjustments, to the portfolio itself maybe you start selling stocks you start moving more to cash you, move to other. Asset. Classes like. Like. Bonds. Or you know who knows what else right. But. We're not talking about that today we're talking about more of a shorter, term outlook, where. A trader, may have the motivation, to reduce risk on their portfolio for. A limited period of time options, no matter how long they are till. Expiration, they are ultimately, limited. Right. Chuck. I do have. A kilt, interesting. Story I don't mind a little sidebar I always think that it's good for you to get to know your presenter, a little, bit more of a personal level and we do have time for a little, bit of a discussion, not just a little quick sidebar I do, own a kit a kilt, if you've ever seen the movie Brigadoon. Which. Is an old, black-and-white. Classic, at least I remember it as being black and white I may need to go back and watch it again. Great movie, it's it's from the set of Brigadoon, now, that means it's a very old kilt and actually. Ultimately it, has started falling apart all the threads are going it has some, waffles in it but I competitive, Scottish games or, Highland Games athlete.
At, A very. High level for a long period of time and, I wore that thing out. Anyway. So. Hedging, is just, taking on. A position. To. Theoretically. Reduce the risk in an existing position so, let's let's. Assume that we, own shares of Apple and we're, looking at it right now and, I'm gonna call today, just day 1 ok, so. Actually let me label this too. Let's. Give. Ourselves some space there we're, gonna call this example. Trade. A. And. This is going to be a covered. Call. Alright. And so on so. A covered call. Has. Two elements that. Requires, stock. Ownership. So. We're. Going to assume that we already own some shares of Apple for whatever reason about a fundamental for fundamental reasons or technical reasons or a combination of both and the. Stock right now is trading look. At that. $198. I'm going to do just a little bit of rounding. So. The price right now is. $198. All, right and let's, say that, we own. 100. Shares. Now. When. Doing covered calls or. With trading options generally speaking, there. There is a. Commitment. To. A hundred, shares when when trading an option each contract, typically, represents. 100. Shares of stock there are some comparatively. Rare examples, to that now that we have options known as minis where it only does 10 shares anyway. So. Let's just assume that we have that we own a hundred shares of Apple we've, taken a look at today's market conditions, in the stock is at 198. But. We think that there may be some looming, weakness, in the stock okay. So. We're gonna say short-term. Outlook. Declining, price. Let. Me spell, it correctly. So. What. Do we do with that information well, if you're if you own a stock and it just goes through its you know higher highs and higher lows on, its way up and that's sort of a technical expectation. A trainer, may choose to do nothing with that information be aware that that's a possibility. However. Something. Else that it that a trader might do is. Sell. A call. So. When you own a stock that stock. Carries with it unlimited. Reward, potential, and interestingly. Enough for, a trader who owns a sick-ass share of stock that, fact, can. Be marketable. To other investors. Or other participants, in the markets so. Here's. What we're thinking of, doing, for. This example is proposed by Dwayne Michelle and Ronald. Maybe. We go to Apple's option, chain you know what this contract, expires, these, contracts, expire right there in 30 days nice round number how about we stick with that I'm. Gonna go out to the 30-day contracts, and what. If we were to look at selling. We. Sell this 19th. Of July, call. For. And. Actually it's the 19th of July, 2:05. Let's be precise here. We. Sell the 205 calls trading between 266. And to 68, I'm going to call it 267. And yes prices, are changing I realize that. But. What we're doing as we. Sell that call is we are making the effort to market, this. Profit. Potential on Apple, now. Effectively. What we're doing here is selling the profit potential of Apple for, the next 30 days how far can Apple travel in 30 days. Ricardo. Says it might have been colorized right what do they call that. Something. Vision techno, Technicolor, right yeah when they first started colorizing, movies right. Right it might have been I can't remember. Anyway. And. Right. Now as we're. Marketing, this. Profit, potential this 30-day profit potential for Apple the. Going, market price of that is around two dollars and 67 cents, so. This is known as a covered cult because if we enter into this contract if, we sell that, 205, call we're, taking upon ourselves an obligation. We're. Obligating, ourselves, that if this stock rally, is up or above 205. Someone. Else has the right to buy those shares from us at 205, so if it's worth 210 220 230 or anywhere higher, they. Have a motivation, now to, buy those shares now. Anytime you get into a short, contract, like this you, do have what's called assignment. Risk assignment, risk means that it's, not in your control when the, other party, chooses. To exercise their. Right to in. This case buy your shares and, assign, essentially. A detail, or the obligations. Of that, contract. Right. Now so. How. Does this hedge the, position, well. With. The stock at 198, let's suppose that we were thinking the stock we're going to slide a little bit okay, so let me again visualize, this there help you visualize this let's, say that between now and that. July 19th, expiration, maybe we need to see that July 19th expiration, let me change my right expansion, settings come down here change, the right expansion, settings right now it's set to 20 bars we. Need 30 days on there because our contracts expire in 30 day that's actually 30 calendar days if we, put 30 bars.
That's, 30 trading, days on there that'll. Certainly capture, that 19th. Of July so, there. We go there's. Our expiration. Here's. Here's, we are on day 1 let's draw a line in on day 1. So. There's our day 1 line and, our. Technical expectation. Is that we're likely to be below, that line at expiration. So. In, reaction. To that expectation. We're, selling, a call up here at 2:05. So. Someone has the right to buy shares from us for 205. And. Theoretically. The risk of that actually happening is much greater if the, stock is actually worth more than 205 right if. The. Stock goes down, what's. Happening the likelihood, that we will ever have to deliver. On that obligation to. Sell our shares of 205 that's getting more and more remote right, that, is in keeping with our technical expectation. For the stock well, another thing is happening here by, selling, this call we've. Collected a credit. So. Let. Me propose, a scenario, for you here what. If the stock were, to drop let's say it goes to. Let's. Say the stock were to go to. Let's. Say 195. If. The stocks at 195, at expiration, is, the. Other trader who has a right to buy shares from us for - from 205 do they have a motivation, to exercise that right nope. Is that are we likely to see assignment, nope, at. Expiration. We, just keep, the, 267. That we collected, and, then. We're relieved of our obligation, so, we have 267. Now in our pockets, that's, been realized, as a gain but. What's happened on the stock well the stock has declined from 198, on day one to. 195, at. Expiration. 30. Days from today so. We have a three dollar loss on our stock a paper, an, unrealized. Loss, from, day one to day 30, but. We have 267. In the. Other hand that. Has largely. Mitigated that, that, short-term drop. In the stock. So. That is, how the. Selling, of a covered call can. Serve to reduce the risk of a trait now. You might say well Cameron why don't I just sell the stock on day one well you could have right, but what if you were what, if you were thinking of holding it anyway, and. You're just doing this in the short term just. During the pullback in this stock. Reducing. The risk through the introduction of covered call so. That's the potential. Advantage. Of the trade what. Have we discussed as a potential disadvantage, at least through the eyes of some covered. Call traders well we. Obligated, to sell the shares for 205 and. If. The stock goes rocketing.
Up. Now. We. Only have limited ability to, participate in that, upward move once, the stock gets above 205, any, gains. Beyond, that if the contract, is assigned, those. Gains go to the, the, owner of the call, so. We've. Farmed, out that. Unlimited. 30-day, potential, on your stock for two dollars sixty-seven, cents that's what it amounts to two hundred sixty seven dollars per contract. So. For some traders, even though they're aware that, covered calls might, serve as a hedge they. Might not be happy, with with. Those. Facts. Those are the facts of the trade, so. What. Else might be done. Let's. So, we just had a covered call as our example trade let's. Copy, this. And. I'm going to do example trade B. Which, is a a. Short. Call vertical. Or Surtur call spread. So. What is that, well. The short call vertical actually, starts, with. Selling. A call. But. At the same moment you. Buy an offsetting. Or at least partially offsetting, call, so, let's go back to our option chain, we. Sold in this example the 205 call let's. Say at the same moment we buy the 210, call. And. That's. Gonna cost us between a buck forty right now a buck forty one let's call it a buck forty okay. There. We go. So. What have we done here well we, collected, a premium. Of two dollars 67. Cents on the short call and essentially, have, spent, a portion of that, to. Buy another. Call so what's. The net credit, on. This. Trade. -. 67. -. The dollar forty that we spent. Is. A. Dollar, 27. So. We. Went from 217. To 67, credit, to. A dollar 27. So obviously that the, credit retained, has gone, down, what. Does that do, to, the hedge of. This. Trade. Well. Let's. Talk through that. But. I can, tell you just quickly. That. That the hedging impact has been reduced why. Would we ever do that when. We could have we could have had a 267. Credit now we're settling for a dollar 27, credit because, there's something else that has gone here gone. On here with a short call vertical it, effectively. Removes. The requirement of stock ownership from, the equation. Why. Is that the case well when you sell a short, call if. That's all you do you have what's called a naked position. If.
You Sell a call you have an obligation to, sell shares for. A fixed, price for a fixed period of time if you don't actually all know shares that position is now naked and if, the stock happens to rally, goes. To 230, 250, 290, 300, and on and on and up. Your. Losses, can, pile up on that trade so. You. Can cover that position. That and cover the naked position, through, stock ownership or. Instead, of owning. The stock you. Can own the right to own the stock which, is what this called us for us now. We know if we purchase this, other call. We. Bought the 210 call for our example today we don't own the stock well, it doesn't even matter if we did really. We. Have the right to own the stock so worst-case scenario if the stock were rallies sharply, and. We have to sell it for 205, we know what. Is the most we would have to pay for the shares to. Cover that position. Most. We'd have to pay is 210. This. Is a covered. Position. So. We've. Done this vertical spread but. We still have stock, ownership right. It's. Not required but we own it so, now. That we have the vertical spread and it's acting. As the hedge on this. Trade. What. Is the, reward potential. Now for the stocks that wheel. For. The stock shares. Stock. Shares are now essentially. Freed up let's. Talk about what. Happens, I'm gonna do a what happens. At. Expiration. If. Okay. We have a number of scenarios. Let's. Look at scenario, number one the stock goes. Down. From. Day. One. Or. Let. Me phrase this a different way. The. Stock is below. 198. That's our day one price right. What. Happens well we, now have a three, legged stool, in our in our trade, we have three, different positions, that, are. Conceptually. Related but. We need to know exactly what happens with each one of those. What. Happens with our stock. The. Stock has a loss right. So. If, the stock let's say let's say the. Stock is below. Let's, say it's gone down to 195 as in our earlier example. Well. If the stock was the only thing we had we it. Was 198. Unrealized. Gain or loss depending on what we paid for at the time but it's dropped, from. 198, to 195. So. We have a from day 1 to day 3, an. Unrealized. Loss, on the stock. And. Let me just raise that this way. There. We go. But. What. About the vertical, spread. What. Does it do if the stock is at is at. Or below 198. At. Expiration. What. Happens with those two calls. Someone. Has the right to buy shares from us for 205 that are only worth 198. Are they motivated to do that nope. We. Have the right to buy shares from someone else for 210 are we motivated, to do that nope. So. The, vertical spread expires. Worthless. Which. Equals. Which. Presents a maximum. Gain. There. We go. So. What we need to do to know exactly, how we performed, is. We'd. Have to just run the math on that so if the stock fell three. Bucks down to 195, well, then we would see a paper. Or unrealized, loss on the. Stock of three dollars. But. The vertical spread has, its maximum, gain, which. Is that dollar 27. So. We'd, have a reduced. Impact. On that. Stock drop so. We have hedged the position, did we eliminate. Risk nope, we. Didn't insure the position, we hedged it there.
We Go all. Right what if let's, let's go to the second scenario. What. If this stock is. Above. 198. But. Below, the vertical. So. The stock has gone from 198, let's say it goes up to 203. Okay. So it's now gone up $5. Well. On the stock. The. Stock has an unrealized gain it's increased, in value and. You might think oh well this is where the, vertical spread breaks down where. It turns out we didn't need this hedge the stock actually did just fine, however. What. Really happened with that vertical spread. Actually. I can even just go like this. Let's. Just copy that and. We're, just gonna paste it right here. Yeah. The vertical spread still expires worthless if, this stock is below 205. Above. 198. So it's below our vertical but above our our, day 1 price on our stock we. Have a gain on the stock but. The vertical spread expires worthless the, trader has a right to buy for 205, stocks. Shares, that aren't worth 205. Unlikely. To assign, the. Fact. That we have the right to buy it to. Buy. The shares from someone else for 210 and they aren't worth 210, those. Contracts, expire worthless and the net. Credit. Is retained. All. Right so this is starting to look like okay great so. Scenario. A is. Better. Than if we just retain, the stock and not done the vertical spread right, because. If you just retain the stock and it went down you just have a loss on the stock and nothing to help help offset scenario. B is even better now. The stock is making money and your vertical spread is making money is that. Always the case is. This always what's, going to happen not. Necessarily, what if. Let's. Look at. Scenario. Number three stock. Is. Above. The. Vertical at, expiration. What's. Gonna happen in that scenario. Well. Above, the vertical means that it has gotten all the way up above to ten all. Right if. It's up above to ten what's, happening to the stock value well we started day one at 198, it's. Gone now 2 to 10 to 15, to 20 the. Higher it goes the more that stock is making. And you might be thinking if. You're an experienced covered call trader yeah but Cameron don't I lose the shares at that point, no. You. Don't lose the shares because. The. Vertical spread acts as, the, covered position. All. Right, so. At expiration. Here's. What may happen with a stock okay let's, let's let's answer that first question. All. Right the, stock, has. An. Unrealized. Gain. Great. Well. What's happened with the vertical at. This point that vertical, has applied. A little bit of drag I don't know if I can classify as a little bit but some drag on the, trade. Because. We. Did we entered into this obligation. We. Have the right to buy shares at 210 we're. Obligated to sell them for 205, though if. Those. Contracts, are both exercised, we lose $5, although. We did have a, dollar, 27. Credit so, the, max loss. For. That vertical, spread is. That. $5, - $1 27. That. Gives us 3 dollars and 73, cents, if, I ever make a mistake in my math please call me out okay. But, at expiration. The. Vertical, spread. Legs. Are. Exercised. Which. Creates a max loss, scenario. There. We go, so. How. Does the trade perform, overall, let's. Talk through this let's, do some real numbers let's, say the stocks at 220. At expiration, could, Apple, conceptually, get to 220, in the next 30 days it could write, my saying is going to nope I don't know the future like that but. If it gets to 220, and. On. Day 1 when we first place this trade Apple, is only worth 198, well we'd have a $22. Unrealized. Gain on the, stock position but. Our vertical spread, both. Those contracts, got exercised, we. Bought it - at 210, sold for 205 $5, lost - our dollar 27, credit so. We have a. 373. Loss on the vertical. But. A $22, gain on the stock and in that case we've. Made money now. When using vertical. Spreads as. A, hedge. This. Is where it differs from a covered call, with. It with a covered, call if the stock goes up to. That call strike that's, where the gain potential, ends.
Until, Expiration, till. The contracts, are assigned whatever. Happens there, Harvey. With. A vertical spread, one. Of the sought keeps going up you're, actually making more and more money on the stock and, the. Drag applied, by the vertical spread is limited, to the maximum, loss of that trade, that's. It so that's why some. Traders may choose and as I'm not saying that all would but. Some might choose to do a vertical. Spread versus, just a covered call. And. Once. Again to emphasize a point there. Are pros and cons to that decision we. Have we've, restored, the maximum, potential or the unlimited upside potential, of the stock, but. At. The sacrifice, of some. Of the hedging. Ability, of the. Of, the the option. Trade and, set up to sixty seven heads we're only getting a dollar 27, hedge. All. Right so that's if the stock is below. Our price from. Day one if it's above the price but still below the vertical what if it's above the vertical what's left for consideration. Two. Final points I want to make before it's letting you loose on this what. If their stock is. Within. The. Vertical. At. Expiration. Chuck. Good question I'll come back to that in just a second here. But. What if the stock rallies, up it goes up to 207. Or 208. So. At expiration, it's, not all the way above your vertical it's right between your two strikes, well. You. Have a trader, here's 205, here's 210. The. Stock is worth more than 205 does, the trader, who has the right to buy your shares for 205, when, they're worth 207, or 208 do, they have a motivation, to exercise, that right they certainly do. With. Very rare exceptions all. In. The money options, are exercised, at expiration, so, assignment. Is a real risk there and, you might think that's okay I'm covered wait a second, are you. Your. 210, is out of the, money stocks, worth let's say 208. We. Have the right to buy shares for 210 that, aren't worth 210, we. Could actually just buy the shares on the open market for 208 that. Contract, expires, worthless it does not cover. The stock, position, and the. Stock shares are sold. So. Do. We need to be aware of that yeah. Stock. Is. Sold. Contract. Is assigned. Alright. And. That's. What happens with the stock shares what. Happens with the vertical spread well. The vertical spread. Is. Somewhere between. Max. Gain, and max. Loss, it. Really depends on how far, above or. How far into that vertical spread it is if it just Peaks a little bit let's say it's at 205, and. Since is. The contract can be exercised, at expiration almost, certainly is okay. So. The shares are sold even, though it's only a few pennies. So, you. Wind up selling the stock at at. Least from. Market. Value just a small loss. Versus. Well. And even for market value it's not really a loss if you're just looking at it from day one you. Wind up you know stock rallied for 198, 205, and it sold for 205. But. You also in, that, case. Retain. The. Net credit, between, the two. Options. And. So there's some money made there on the option, as well or on the on the vertical spread as well so. It's not that that's an unprofitable, outcome. It's not. There. Is a scenario, and this brings me to my final point I said there were two things that I wanted to make sure that we cover before to wrap up what. Is the worst-case, outcome. For this trade. Where. Is the most damage, done it's, actually right up here, in. Scenario. One if, the, stock is below 198. That's. Where you can have losses, we even Illustrated, that to some extent we said well what if the stock dropped to 195, we, have a three dollar loss on the stock at 267.
Gain On the vertical spread and it's, pretty close to a wash well what if it wasn't a three dollar loss what, if it was five or ten, or 20 or 50. Does. This strategy, act as a perfect, pet and actually I said 267. It's, not 267. With this vertical spread it's at dollar 27. So if I said 267. Earlier remember with the vertical, it's. That that, lower net credit so it so if we had a $3 drop on the stock you. Have a dollar 27. Of hedge so. Net between the two lost. About a dollar 73. Any. Anyway the. Further the stock goes that's where the real exposure, lies. So. Is this a strategy that a trader would employ, if they, saw a collapse. Forthcoming, on a stock if they if they really believe that maybe. Not right, in. Any case there we go so that, is how a verb spread may be used as a hedge we've looked at the the, pros and the cons what, happens, as we, get to expiration now Chuck's ask the final question so, do you want to close this out before expiration. You, certainly might, choose to although, not necessarily in every circumstance. Just be aware that whenever you. Are in a trade of. Where. There's a short. Option. Involved, the, risk of assignment, is there. Just. Everyday, right up till you exit or until you hit expiration. But. You know if it let's say the stock is let's, say it's still. Below the vertical spread vertical. Is out of the money and you just get closer and closer and closer to expiration, well. If you can push that all the way to expiration then, that vertical just expires worthless so you're not necessarily. Obligated. To close it out just. Be aware that every day you extend, the trade is another day where, there's some risk that the trade could go the other direction. Maybe. An assignment, happens unexpected, to leave something like that. Let's. Seize Chuck says since, you're hedging for a short period of time to get the max gain on vertical why not do a vertical for a shorter, period of time and, you could Chuck just be aware that as you go with, shorter, term, vertical, spreads that credit, can shrink unless you push it further or. Push. It closer to an at the money trade. All. Right. And. Kerry says what about selling the 210 and buying the 205, so. So, Kerry that would actually be a. Debit. Spread a bullish. Debit, spread that, wouldn't actually act as a hedge at all that would actually just be adding one bullish trade to another bullish trait so, if the stock went down you. Get to be kind of a double whammy scenario, we're, now you're losing money on two trades, whereas. The way that we constructed, this if the stock goes down yeah you're losing money on the stock in the short term as you expected, but. Theoretically. Making, money and. Unrealized, gains until expiration or until exit on the, vertical spread. Everybody. There we go a detailed, discussion, of vertical spreads here's what we did in. Just 45 minutes you, got an introduction to hedging we. Discussed that potential, head strategy, and used. Example. Trades, so. I want, you to walk away with this understanding that there are multiple, option. Strategies, that might be employed if, a short-term. Downturn. Is seen on a stock and. If you want to try that in your paper money this might be a good time to do it to cement these concepts, hey, thanks for joining me today everybody I'm gonna set you loose but.
Coming, Up in just 16, minutes as James Boyd again I know he just wrapped up he's coming back again to discuss, directional. Options strategies very nice stuff tale discussion, with this discussion, so. Go enjoy James if you could fill out my survey, I always. Appreciate, that some of you do it every time thank you keep doing it if. You haven't done it before just click the link it's five multiple choice questions superfast but it helps us improve, our sessions. All. Right everybody. I'm. Going to set you loose quick, reminder, of the risks associated with your investing, though risks. Are real. We. Did use real examples, in today's discussion it's not a recommendation or endorsement of those securities, or those strategies and the usage of a stop order is not a guarantee that you buy or sell a specific price I will. See you again next week between now and then I want to wish you the very best of luck happy. Investing bye, bye. You.