When starting small, it can feel like a real challenge to grow your investment account. Sure, you would likely see bigger returns if you had a massive portfolio. But you might also see some big losses. There is nothing wrong with starting with a modest investment portfolio. It can grow and you can see substantial products down the line. Investing is a long game, so it’s time to practice patience.
When it comes to growing your portfolio, one strategy you can consider is using vertical spreads. This options trading strategy makes it possible for you to manage risk, all while generating consistent income that you can use to make even more investments that can lead to more growth (picture a snowball rolling down a hill). Let’s explore what vertical spreads are and take a look at how to use them to grow your small investment account.
What are Vertical Spreads?
If you aren’t familiar with what vertical spreads are, the concept can be a bit confusing at first. When you hear someone use the term vertical spreads, they are referring to the processes of buying and selling two options that are of the same type and have the same expiration dates, but differ in their strike price. One type of option is called a call option and gives the option buyer the right to buy the underlying asset at a specified price within a specific timeframe. They can be bought when anticipating the asset's price to rise. Conversely, a put option provides the option buyer the right to sell the underlying asset at a predetermined price within a specific period, and are often bought when expecting the asset's price to fall. Both options allow investors to speculate on price movements without owning the actual asset.
There are two broad categories of vertical spreads, bull spreads and bear spreads. Within each category there are two sub-categories, call spreads and put spreads. For example, a bull call spread can be used when anticipating the price of the underlying asset to increase and utilize call options to execute the strategy.
Let’s be specific, a bull call spread is when you buy and sell two call options. You are buying the call option with the lower strike price and selling the call option with the higher strike price. At first this will result in a net debit to your account, which represents the maximum loss of the trade. But if the underlying asset increases in value to be above the call option you bought (the lower of the two strike prices) you start to see returns by taking advantage of the call you bought. You break even when the asset price equals the lower strike price plus the premium you paid and your maximum return is reached when the asset price reaches or exceeds the strike price of the call option you sold (the higher of the two prices). The maximum return is then difference between the two strike prices (the spread) minus the net premium you paid for the options (the net debit that was applied to your account when you first executed the trade).
How to Conduct Vertical Spreads
If you decide vertical spreads are the right approach for your investment portfolio, these are the steps you should generally take to get the job done.
- Step 1. Educate yourself. You need to understand the basics of option trading before you start with vertical spreads. Take some time to learn how vertical spreads work and what risks you can face in pursuit of rewards.
- Step 2. Choose a reliable broker. You don’t need to do this alone—make sure you are working with a brokerage platform that offers options trading, provides educational resources, and has a user-friendly interface and reliable customer support.
- Step 3. Evaluate risk. Before you start a vertical spread, determine your risk tolerance and set a budget for your options trades. You should only invest what you can afford to lose.
- Step 4. Identify suitable stocks. Look for liquid stocks with options available and consider stocks with consistent price movements and sufficient volatility.
- Step 5. Execute your trade. Once you have a plan in place, it’s time to execute the vertical spread. You will need to buy/sell options of the same type but differ in strike price. Then specify the number of contracts, the expiration date, and the strike prices. From there, you will monitor the trade to ensure it's executed at your desired prices.
- Step 6. Manage your risk. To limit potential losses, implement stop-loss orders and diversify your trades. Doing so will help you avoid putting all your capital into a single trade.
- Step 7. Make adjustments as needed. Don’t just walk away after a vertical spread and hope for the best. You need to regularly review your trades and learn from both successes and failures. That way, you can promptly adjust your strategies based on changing market conditions and the lessons you learn as you gain trading experience.
Why Vertical Spreads Help Small Accounts Grow
So—why should you pursue vertical spreads with the goal of growing your small account? Vertical spreads allow you to execute a trade that gives you more control over how much risk you are taking, but this comes at the cost of limiting your maximum return. They can be used to help manage overall account volatility while growing your portfolio with each successful trade.
Get started with Tiblio's market data and tools including our proprietary vertical spreads screener to learn how to trade vertical spreads and create a strategy that works for you today!