Quote from sukikra:
ok i understand that the strategy has a negative net delta.
But how does the strategy lose money in real terms?
With the strategy costing flat, then if the underlying goes up, it doesnt matter as the short puts wouldnt get exercised.
If the market goes inbetween 118-117 couldnt the owner of the strategy just unwind it, and selling the strategy for much more due to the long puts having intrinsic value now. (thus never allowing the strat to go below 116 breakeven).
So how come one in real terms lose money ? sorry maybe for the newbie question but cant figure it out.
The best way to get a sense of the profit and loss potential for this and any trade, I think, is to simply have a look at a risk graph. The following site has risk graph and prose explanations of almost every type of option strategy possible:
http://www.optionsatoz.com/Library/ReferenceDesk/OptionRiskProfiles.aspx
I don't know if its the best site of its kind, but it's at least a decent jumping off point. Optionetics offers a free trial where you can input the trade and it will bring up a risk graph on your specific trade. You can then customize it to find out what would happen if implied volatility changes, p&l on any given day during the trade's life, etc.
About your trade, I don't like the term "1 by 2," the pet name used by all those gurus on CNBC and their option action show. You'll never see the term 1 by 2 in any of the major books on options. That name says nothing about the trade. Your trade is a classic frontspread. It's the opposite of a backspread and has an opposite risk profile. It's also (and probably more often, these days) referred to as a vertical ratio spread. It's usually done for a slight debit or even money if you're lucky (as it was in the case you cited), but can occasionally be put on for a credit. As you will see when you explore the risk graph, you can definitely lose money on this trade, although I for one think it's a very good trade and the probability of being profitable on this trade is statistically good, all things being equal. The important thing to remember is that it is net short of options. You have a bear put spread that makes money as the market moves down and you're financing it with a farther out of the money short put, which loses money as the market moves down. The trade will perform well if the underlying stays flat or moves lower fairly slowly and gradually, and doesn't go too far below the short strike. Fast and big moves are the enemy of this strategy. If the market makes an abrupt move lower, the trade won't have had the opportunity to benefit from the the passing of time and the short puts (negative gamma) will really begin to drag on the position. Yes, you could unwind it at any time, but you'll have to book a loss (albeit relatively small, if you're nimble and vigilant). What you need is a good resource on trade management. Anthony Saliba's books offer concrete, practical tips on managing losing trades. I don't normally trade this one so I don't have too much to say. For very good information on the mechanics of the trade itself, there is no better resource than Macmillan's books, notably __Options as a Strategic Investment__. Again, though, check out a risk graph so you can see how the trade performs through various permutations of price and time.
