What to do When Your Short Vertical Spread Gets Tested
What to do When Your Short Vertical Spread Gets Tested
Entrance and exit strategies seem clear enough, but what should you do in between?
Short Vertical Spreads are great short premium strategies that enable you to play direction with limited risk.
If the position is out of the money and working—or in the money and not working—the best strategy is almost always to do nothing.
If the position is around your strikes, then roll to the next month if you’re at or inside of 21 days to expiration, and you can roll for a credit.
Inside of the tasty world, trade entry and trade exit for a short vertical spread are fairly straightforward. At trade entry, you look for high liquidity and elevated volatility, and play direction based on your own personal feelings or your portfolio targets. At trade exit, you look for your profit target on your winners and accept max loss on your losers. But over the life of the trade, what do you do for everything in between?
Here is a three-step process for short vertical spread trade management.
Step 1: Do nothing
Often, you should choose the “do nothing strategy.” When a trade is working, there is no need to override the process and start fiddling with the position. A common mistake that newer traders make is always feeling the need to tinker with their trades. Doing this frequently leads to a worse outcome, especially with trades that are profitable out of the gate and start working right away.
Therefore, when the options are out of the money and the stock is moving in your favor, resist the temptation to overmanage. Wait for your profit target and simply do nothing in the meantime.
Step 2: Rolling for a credit
Sometimes, however, your short vertical spreads won’t be working and will require an adjustment. This is when you would look to roll the short vertical spread out to the next month. To do this, make sure two criteria are met:
The trade is at or inside 21 days to expiration (DTE) in the cycle. Given the defined-risk nature of a short vertical spread, you don’t want to adjust too early. Instead, give it enough time to work on its own.
The position can be rolled for a credit without changing the strikes. By doing this, that added credit improves the risk-return relationship of the trade by increasing its profit potential and decreasing its maximum loss.
Step 3: Do nothing—again
If the stock has moved significantly against you, and the short vertical spread is fully in the money, this is another situation where the best move is almost always to do nothing. Yes, you could add some time to the trade and roll out to the next cycle, but that will almost assuredly cost you a debit.
If you roll for a short vertical for debit, then you would be adding risk to the trade. From a risk management standpoint, it’s much better to keep the risk on the trade set to what you had at trade entry, and be prepared to carry the trade all the way to expiration and accept max loss, if need be.
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
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