Basic Question on Vertical Spreads

[rrisch]

I have been experimenting with vertical call spreads of the following kind. I buy a long term (now, usually Jan05), slightly OOM call and sell the same expiration call one or two strikes above the one I bought. I try to get a debit, at most 1/3 the difference between the strikes. I restrict myself to stocks which I feel are quite undervalued. Many of these options are sparsely traded.

My question has to do with when to close such a spread. I find it unpredictable when the spread value will rise. However the win rate for such plays seems quite high. Often the value doubles long before expiration. The theoretical maximum is the difference between the two strikes. However I notice that even when both legs are deep in the money, the closeout value is often more than a dollar below that difference. I think that as you get closer to expiration and/or the spread gets deeper in the money, the closeout value improves slightly. Can anyone suggest rules of thumb on when you should close out the spread so as to establish another one using higher strikes? Thanks.

 

[weewilly]

watching spreads move on distant option series is like watching paint dry.....keep those babies closer in (< 3 mo) if you want to see them widen.

as for how to manage a winner, it's a nice problem to have. one thought is to sell half if you get a double and ride the remainder out for free.

as for wide spreads on the itm's, i suspect the problem is again that you are trading spreads on series with way too much time remaining. nearer series will widen faster as your stock moves, and as they go itm. better liquidity and tighter spreads on the front months too.

wee

 

[riskarb]

Quote from weewilly:

watching spreads move on distant option series is like watching paint dry.....keep those babies closer in (< 3 mo) if you want to see them widen.

as for how to manage a winner, it's a nice problem to have. one thought is to sell half if you get a double and ride the remainder out for free.

as for wide spreads on the itm's, i suspect the problem is again that you are trading spreads on series with way too much time remaining. nearer series will widen faster as your stock moves, and as they go itm. better liquidity and tighter spreads on the front months too.

wee

Verticals don't get significantly cheaper the further you go out in time, that's rule #1, so stay away from back-month verts.

riskarb

 

[rrisch]

Sorry guys. I respectfully disagree. For the class of stocks that I enter such spreads, the win ratio increases dramatically as I go further out in time. That is the point. I might have 100 going at the same time.

I have noticed that after both legs go sufficiently itm, the price to enter the spread becomes higher than the difference of the strikes while the price to close out the spread remains lower. Is that the optimal time to close it out? Is it worth waiting an extra month with the hope that the close out value will get closer to the difference in strikes?

 

[weewilly]

not sure with what exactly you disagree.... let me pose this question. if you must buy a 45/50 call bull spread, and you know in advance that in 60 days the stock will move from, say 45 to 50, would you rather own the spread that expires in 3 months or the one that expires in 1 year (assuming similar IVs)?

 

[rrisch]

Quote from weewilly:

not sure with what exactly you disagree.... let me pose this question. if you must buy a 45/50 call bull spread, and you know in advance that in 60 days the stock will move from, say 45 to 50, would you rather own the spread that expires in 3 months or the one that expires in 1 year (assuming similar IVs)?

Well of course I would. The trouble is that for my class of stocks, there is a high probability that the advance will be within one year and the distribution of when it happens in that period is a uniform one. I am not smart enough to pick issues, a high percentage of which, will advance in the next 60 days. Are you?

 

[weewilly]

Quote from rrisch:

I have noticed that after both legs go sufficiently itm, the price to enter the spread becomes higher than the difference of the strikes while the price to close out the spread remains lower.

Um... it is universally true that what you pay for anything is, at the moment of the transaction, higher than the price you can sell it for............As for the itm call spreads, or any call vertical spread for that matter, I have never seen them quoted at a price that exceeds their maximum possible intrinsic value.

 

[iceman1]

Quote from rrisch:

I have been experimenting with vertical call spreads of the following kind. I buy a long term (now, usually Jan05), slightly OOM call and sell the same expiration call one or two strikes above the one I bought. I try to get a debit, at most 1/3 the difference between the strikes. I restrict myself to stocks which I feel are quite undervalued. Many of these options are sparsely traded.

My question has to do with when to close such a spread. I find it unpredictable when the spread value will rise. However the win rate for such plays seems quite high. Often the value doubles long before expiration. The theoretical maximum is the difference between the two strikes. However I notice that even when both legs are deep in the money, the closeout value is often more than a dollar below that difference. I think that as you get closer to expiration and/or the spread gets deeper in the money, the closeout value improves slightly. Can anyone suggest rules of thumb on when you should close out the spread so as to establish another one using higher strikes? Thanks.

interesting post... provides real insight into your view of trading. Re-read it a few times and ask yourself upon what do you base your seemingly over-confident viewpoint.... such as "the closer you get to expiry the spread gets deeper in the money", or did I misunderstand your example???! Either way it sounds like you expect it to get ITM. For SURE! Curious.. how did you determine that?

Doesn't it sound just a bit like you are 100% certain of your profits, and have already begun counting your chips.... ??! Sure does to me. Yet you might be sitting at the table for a long time, and might even...... LOSE! Now how is that possible with your perfect analysis of "value"?! Always love when a "trader" uses the term "undervalued"... ugh?! The kiss of death. Kind of like bubble-head analysis.

Hmmmmmmmm... amateurs and losing traders only think of what they can make...... professionals consider what they could lose

regards

Ice

 

[GATrader]

Robert, you must be looking at stale quotes for a spread to be trading more than its worth at exp

 

[rrisch]

Quote from iceman1:

Re-read it a few times and ask yourself upon what do you base your seemingly over-confident viewpoint.... such as "the closer you get to expiry the spread gets deeper in the money", or did I misunderstand your example???! Either way it sounds like you expect it to get ITM. For SURE! Curious.. how did you determine that?

What you put in quotation marks is not a quote from me. What I am confident of is that I can pick a class of stocks, which with high probability, will go up at least 1 to 2 strike prices within a year. I cannot place when that happens with greater accuracy. My post just shows I am fishing for information on how to play my selections.