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Case Study: A Winning Vertical Spread Trade

📈 Putting It All Together: A Real-World Example​

Theory is essential, but seeing it in practice is where the lessons truly solidify. In this final article of the chapter, we will walk through a complete, real-world vertical spread trade from start to finish. We will apply all the concepts we've learned: forming a market outlook, analyzing implied volatility, selecting strikes using delta, defining our risk-to-reward, and managing the trade to a successful conclusion.

This case study will demonstrate how these individual components come together to form a coherent, disciplined, and profitable trading process. We will see how a trade can be structured to have a high probability of success from the outset, not through guesswork, but through a systematic application of the principles of options trading.

The Scenario: Pre-Earnings on a Stable Stock​

  • The Stock: "StableCorp" (ticker: STBL), a large, well-established consumer staples company known for its predictable earnings and low volatility.
  • Current Price: $155 per share.
  • The Catalyst: STBL is scheduled to report earnings in one week. This is a known event that injects uncertainty into the market.
  • Market Conditions: The broader market is calm, but as is typical before an earnings announcement, the Implied Volatility (IV) for STBL's options is highly elevated. The IV Rank is 85, meaning its current IV is in the 85th percentile of its 52-week range. This tells us that options on STBL are currently very expensive compared to how they have been priced over the last year.

The Trade Plan: A High-Probability Bull Put Spread​

Our analysis leads us to the following conclusions:

  1. Outlook: We are neutral to slightly bullish. STBL is a stable company and is unlikely to experience a massive post-earnings collapse. We don't need it to rally; we just need it to not fall apart.
  2. Volatility: The IV Rank of 85 is extremely high. This is a prime opportunity to be a premium seller. We want to take advantage of the expensive options and the subsequent "IV crush" that will occur after the earnings are released.
  3. Strategy: Based on our outlook and the high IV, a Bull Put Spread (a credit spread) is the ideal strategy.

The Plan:

  • Strategy: Sell a Bull Put Spread.
  • Profit Target: 50% of the maximum profit.
  • Stop Loss: If the trade loses 2x the credit received.
  • Justification: We are selling expensive "fear" premium with a high probability of success, and we have a clear exit plan for both a winning and a losing scenario.

Execution: Selecting the Strikes​

With the stock at $155, we open the options chain for the monthly expiration cycle that occurs just after the earnings report (about 10 days away).

  1. Finding the Short Strike: We look for a put strike with a delta of approximately .30. This gives us a ~70% probability of profit. The 145-strike put has a delta of .28. This is our target.
  2. Defining the Risk: We decide on a $5-wide spread to define our risk. We will buy the 140-strike put.
  3. Checking the Risk/Reward:
    • Sell the 145 Put for: $1.80
    • Buy the 140 Put for: $0.80
    • Net Credit: $1.80 - $0.80 = $1.00
    • Spread Width: $5.00
    • Max Loss: $5.00 - $1.00 = $4.00
    • Risk/Reward Ratio: $4.00 / $1.00 = 4-to-1.
    • The 1/3 Rule Check: Is the credit ($1.00) at least 1/3 of the spread width ($5.00)? No, $1.00 is less than $1.67. However, given the very short timeframe and the high probability event, we decide this is an acceptable trade-off.

The Final Trade:

  • Sell to Open: 1 STBL 145 Put
  • Buy to Open: 1 STBL 140 Put
  • Net Credit: $1.00 ($100 per contract)

Immediately after the trade is filled, we place a GTC order to buy the spread back for $0.50 (our 50% profit target).

The Outcome: Managing the Winner​

  • Earnings Day: STBL reports earnings that are in line with expectations. The stock moves down slightly to $152, but remains well above our short strike of $145.
  • The IV Crush: As predicted, the uncertainty vanishes overnight. The IV Rank plummets from 85 to 20.
  • The Result: The combination of the stock holding its ground and the collapse in IV causes the value of our spread to decay rapidly. Two days after earnings, our GTC order to buy the spread back for $0.50 is filled.

Trade Summary:

  • Credit Received: +$1.00
  • Debit Paid to Close: -$0.50
  • Net Profit: +$0.50 ($50 per contract)
  • Days in Trade: 4

💡 Conclusion: A Disciplined, Repeatable Process​

This case study demonstrates the power of a disciplined, process-driven approach to spread trading. We did not need to predict the future. We simply identified a high-probability scenario, chose the right strategy for the IV environment, defined our risk and reward, and managed the trade according to our pre-defined plan.

This is the essence of mastering spreads. It's not about hitting home runs; it's about consistently hitting singles by putting the odds in your favor, trade after trade.

➡️ What's Next?​

Congratulations on completing this deep dive into vertical spreads! You now have a powerful set of tools for a variety of market conditions. In the next chapter, "Trading Volatility," we will explore strategies like straddles, strangles, and iron condors that are designed to profit from changes in volatility itself, regardless of direction.

📚 Glossary & Further Reading​

Glossary:

  • Case Study: A detailed analysis of a specific example to illustrate a principle.
  • IV Rank: A measure of current IV relative to its 52-week high and low.

Further Reading: