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Managing Short Vertical Spreads

By:Dr. Jim Schultz

Some go your way, some go against you. Here is what you need to know.

  • With a short vertical spread that goes your way, just wait until you hit your profit target (50% of max profit) and take it off—don't overthink it.
  • With a short vertical spread that goes against you, roll into the next expiration cycle—but only if you can do so for a credit.
  • If your only option on a losing short vertical spread is roll for a debit, just hold the position and be prepared to carry it all the way to expiration if need be.

A short vertical spread is a classic defined-risk, directional strategy that offers a great, short premium option for a beginner trader looking to get started the world of options. Just follow the tastylive mechanics.

And the way it usually sets up is you sell one out-of-the-money (OTM) option and buy a second further OTM option, where we’re looking to collect around half the width of the strikes in credit on the trade. Targeting this level of credit on trade entry gives us a nice risk-return balance, in exchange for a high-probability set up. 

OK, simple enough. But now that the trade is on, how do you manage it?

Managing winners

With the winners, the process couldn’t be simpler. You have a bullish strategy with a short put spread and the stock goes higher, or you have a bearish strategy with a short call spread and the stock goes lower. Either way, your short vertical spread is going to work really well. 

So, you can set your target at 50% of max profit—the level we like to target—and once it gets there, don’t overthink it. Take it off, move on and look for a new opportunity.

Managing losers

Unfortunately, all of your trades can’t be winners. So, what do you do with the ones that don’t work so easily? Thankfully, this is pretty simple, too. Once you get to 21 DTE (days to expiration), look to roll this position to the next monthly cycle. Don’t change the strikes, and don’t add units. Just simply pick up the position and move it forward, but ONLY IF you can do so for a net credit.

By rolling for a credit, you’re able to reduce your overall risk in the position and increase your potential profit: a win-win. So when this sets up, it’s an easy choice. However, you won’t always be able to roll your short vertical spreads forward for a credit. If the position is too far gone (too far in-the-money), it will likely be a debit to roll. So in this situation, you do not roll. You sit and wait and carry the position inside of 21 DTE. Your max loss is already set, so there isn’t a ton of additional risk in holding the position all the way to expiration if need be.

What about the rest?

Sometimes, you'll be at 21 DTE, and the position is only a small winner, or it hasn’t quite hit your profit target yet. Do you roll it forward or take your profits here?

Well, this is largely going to be up to your judgment as a trader, but a good guide to lean on is the implied volatility rank (IVR). If IVR is still on the higher side (a relative thing that you’ll have to use your experience to gauge), then consider rolling. But if IVR has collapsed from where it was when you entered the trade, then it’s probably time to take it off and move on.

Jim Schultz, a quantitative expert and finance Ph.D., has been trading the markets for nearly two decades. He hosts From Theory to Practice, Monday-Friday on tastylive, where he explains theoretical trading concepts and provides a practical application of those concepts to a trading portfolio. @jschultzf3

For live daily programming, market news and commentary, visit tastylive or the YouTube channels tastylive (for options traders), and tastyliveTrending for stocks, futures, forex & macro.

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