Are You Closing Vertical Spreads Too Soon?

Key Concepts

Vertical Spreads: Options strategies involving buying and selling options of the same type (calls or puts) with the same expiration date but different strike prices. They offer limited risk and limited reward.
Binary Payoff: A characteristic of vertical spreads where the outcome is often either zero profit/loss or maximum profit, with a narrow range of intermediate outcomes.
Bell Curve (Normal Distribution): A statistical representation of the probability of different stock prices at expiration, showing that extreme outcomes (both maximum gain and maximum loss) are more likely than intermediate outcomes for vertical spreads.
Theta: A measure of time decay in options.
Gamma: A measure of the rate of change of an option's delta.
Delta: A measure of an option's sensitivity to changes in the underlying stock price.
Trading the Issue vs. Trading the P&L: A philosophy of making trading decisions based on the underlying market conditions and strategy objectives, rather than solely on the current profit or loss of a position.

Summary

This video from Market Rebellion, hosted by Bill Johnson and Stu, delves into a nuanced aspect of trading vertical spreads: the common tendency for traders to close these positions too early, thereby forfeiting potential maximum gains. The core argument presented is that while vertical spreads are known for their limited risk and reward, many traders fail to utilize their full potential due to a psychological inclination to "lock in" small profits, which can ultimately lead to long-term losses.

The Problem with Closing Vertical Spreads Too Soon

The central thesis is that most vertical spreads exhibit a "binary payoff" characteristic. This means that at expiration, the outcome is statistically more likely to be either a complete loss (zero value) or the maximum possible gain (the difference between the strike prices). Intermediate profits, while seemingly attractive, represent a much smaller probability of occurrence.

Supporting Evidence and Reasoning:

Statistical Distribution: The presenters illustrate this using simulations and statistical concepts. They explain that the distribution of possible stock prices at expiration, when plotted, forms a bell curve. For a vertical spread, the range between the strike prices represents a relatively narrow portion of this curve. This implies that the stock price is more likely to end up either significantly below the lower strike or significantly above the higher strike (depending on the spread's direction) than precisely within the spread.
Simulation Results: A simulation using an Excel spreadsheet demonstrates this phenomenon. By running thousands of random stock price paths, the results consistently show a high percentage of outcomes at the "bookends" (maximum loss or maximum gain) and a much smaller percentage of outcomes in the intermediate range. For example, in one simulation with 30 days to expiration, approximately 44% of outcomes resulted in maximum loss, while 30% resulted in maximum gain, with only small percentages falling into intermediate profit zones.
"Picking Up Nickels in Front of Bulldozers": This analogy is used to describe the practice of closing a spread for a small profit. While the percentage return on the initial investment might look impressive, the consistent exposure to the high probability of a total loss (the "bulldozer") will eventually lead to significant financial depletion.

Why Traders Close Early

The presenters identify several reasons for this behavior:

Psychological Comfort: The desire to "lock in" gains and avoid the risk of losing a paper profit is a powerful psychological driver.
Misunderstanding of Limited Risk/Reward: Traders focus on the "limited risk" aspect and equate it with a need to secure any profit quickly, rather than understanding the probabilistic nature of the reward.
Focus on Percentage Returns: Small profits on a relatively small initial investment can appear as very high percentage returns, leading traders to believe they are being highly efficient.
Emotional Trading: Decisions are often driven by the current P&L (Profit and Loss) rather than the underlying strategy's objective.

The Case for Holding Out for Maximum Gains

The argument for holding vertical spreads until closer to expiration or until they reach their maximum potential is based on balancing the probabilities:

Balancing Probabilities: The significant probability of achieving maximum gain serves as a counterbalance to the significant probability of incurring maximum loss. By closing early for small profits, traders eliminate the possibility of this counterbalance.
Time Decay (Theta) and Gamma: As expiration approaches, the impact of theta (time decay) and gamma (rate of change of delta) becomes more pronounced. For a debit spread that is in the money, time decay can accelerate the path towards maximum gain, especially as gamma increases.
"Not Bearish" vs. "Bullish": The presenters distinguish between being truly bullish (requiring the stock to move significantly) and simply "not bearish" (where the stock just needs to stay above a certain level or within a range). For spreads that have moved favorably, the objective shifts from active bullishness to avoiding a downside reversal. In such cases, holding for maximum value is often the correct strategy.

When to Consider Closing Early (Exceptions)

While the general advice is to hold for maximum gains, there are exceptions:

Significant Change in Opinion: If the fundamental outlook for the underlying stock has drastically changed, it may be prudent to exit the position.
Approaching Expiration with High Gamma: When very close to expiration, and the stock price is near the short strike, the high gamma can lead to rapid P&L swings. In such scenarios, especially with upcoming volatility events like earnings, closing the position might be considered to avoid a sudden reversal.
Unwinding for a Better Opportunity: Traders might close a spread for a slightly reduced profit if they have a compelling reason to deploy capital into a new, more advantageous trade.

Technical Concepts Explained

Black-Scholes Model: Mentioned as the basis for calculating option prices, which considers factors like stock price, volatility, interest rates, and time to expiration.
Volatility: The degree of variation of a trading price series over time, measured by the standard deviation of the logarithmic returns. Higher volatility generally leads to higher option premiums.
Delta: Represents the expected change in an option's price for a $1 change in the underlying stock's price. For a call option, delta ranges from 0 to 1; for a put option, it ranges from -1 to 0.
Gamma: Measures the rate of change of an option's delta with respect to a $1 change in the underlying stock price. High gamma means delta changes rapidly.
Theta: Measures the rate at which an option's value decays over time. Positive theta means the option loses value as time passes, while negative theta means it gains value.
Debit Spread vs. Credit Spread: A debit spread is established for a net cost (debit), while a credit spread is established for a net credit received. The theta and gamma characteristics can differ significantly between these two types of spreads depending on the stock price relative to the strikes.

Practical Application and Framework

The video presents a framework for approaching vertical spreads:

Understand the Probabilistic Nature: Recognize that vertical spreads are often binary in outcome.
Resist Early Profit Taking: Avoid the temptation to close for small profits, as this forfeits the potential for maximum gain and leaves you exposed to disproportionate losses.
Hold for Maximum Potential: Aim to let the spread reach its maximum value, as the probabilities statistically favor this outcome over intermediate profits.
Trade the Issue, Not the P&L: Base decisions on the strategy's objective and market conditions, not solely on the current profit or loss.
Consider Exceptions: Be aware of specific circumstances (e.g., major opinion change, extreme gamma near expiration) where closing early might be justified.

Conclusion

The overarching message is that a fundamental misunderstanding of the probabilistic nature of vertical spreads leads many traders to prematurely close profitable positions. By embracing the concept of holding out for maximum gains, traders can better balance the risk-reward profile of these strategies and improve their long-term profitability. The presenters emphasize that this approach, while counterintuitive to some, is rooted in statistical analysis and professional trading experience.