Let me set the scene right now. You’ve just spent three hours doing intense research finding the perfect stock to buy and hold for the next couple of days so you can reap in the wonderful profits. The market opens you find your option contract - exact strike and date - set your limit sell and BAM! You’re in.
You’re suddenly up 10% within a minute.
Three minutes in your stock has increased eighty cents and you’re 30% up. Wow!
Five minutes later you’re sitting at 65% gains.
This is unbelievable.
What’s going on!?
You tell yourself you need to sell.
But you can’t. You have no day trades available.
How many times have you found yourself in a similar situation? Of course, those profits may be exaggerated but there might be a time when you expected to hold overnight for 10-15% and suddenly find yourself above that. It can be frustrating because what happens if you hold? What happens if the stock pulls back and the sellers start taking profit. Are you going to be left behind? In many cases you will. However, it doesn’t have to be that way!
We can actually lock in profits right now even without a day trade available.
Yep! You can do this by opening a Vertical Spread. Now because we aren’t buying together it won’t be 1 contract. However, it acts as the same.
So how do we do this?
It’s simple! Let’s look at an example:
Let’s say we purchased a put on BAC with the $29 strike price and a March 1st expiration and we got in with an 80 cent buy. Now our option is trading at $1.10 and we want to lock in gains.
So what we do is the following:
- Go to the March 1st expirations for BAC.
- Instead of looking at the BUY options look at the SELL
- Since we purchased the $29 Put we want to SELL a put contract and decide to sell the $28.5 Put for 70 cents.
- We now receive a $70.00 credit
So as of right now what have we done? Well, we are up $30.00 per contract on our original buy. We have now sold our second contract and received a credit of $70.00. Assuming nothing more happens and tomorrow the stock opens up exactly the same we may lose a little value to theta and the morning spread but essentially you’ll be up about the same amount.
Now, whenever you go to cash in the next morning you have to do the following:
- BUY back the contract you sold. To do this all you have to do is go to the $28.5 Put and BUY the contract. This will relieve you from the contract you sold.
- Once you have bought back the contract you sold you will be left with your original option contract that you bought. So now you need to close out this original contract.
- Do your happy dance and make it rain dollar dollar bills!
Opening a Vertical Spread can help lock in money. It doesn’t always work though. If the stock begins to decrease in value overnight you may end up losing money on the original contract but because you sold a contract at the higher price as it decreases in value the more money you get to keep from it. However, let’s say something dramatic happens and the stock gaps down well below your original entry. Sure, you may be up on the credit sell you made but you might be down so far on the original contract that overall you’re now losing. The great thing is though even if you hadn’t opened the Vertical Spread you would have been down so essentially by doing the spread you limit the loss a bit.
Now, let’s say the next morning BAC continues to rise and has gapped up and your original contract has increased by another 20%. Well, you’re going to down the contract you sold as it has increased but the original option is going to be worth more so by hedging with the SELL contract you have essentially safely locked in gains without risking too much of your capital overnight.
Hopefully this helps!