Methodology of the DITM Vertical Bull Call Spread

URSA How can I argue with your analysis? You are absolutely correct, that is exactly what the odds say.
In fact that analysis stretches out to every investment vehicle doesn’t it? If you buy a 7% bond, doesn’t that mean that if you buy 100 such bonds 93% would pay you the 7%, and 7% of them would return nothing? Shouldn’t we all just buy CDs and relax? Some investors make money and some lose money. Is it all just odds and luck?

Who is saying there is no need for caution?
Who is proposing wild abandonment in accepting this strategy?
Who is saying this strategy is perfect for all market conditions?
Who is saying all other strategies suck big time?
Let’s find the S.O.B. and kill him!!!!

Who is saying this strategy is a good one for novices to learn about, and apply when market conditions are correct?
Who is saying that the built-in safety in the DITM vertical spreads tend to benefit conservative investors?
Oh - That would be me!

You know, we focus a lot of the problems we might encounter. That is wise and prudent, because it hurts to get bit on the butt. But good things happen too. And when the DITM vertical bull spread is implemented correctly, most of the time good things do happen. We already looked at the odds showing that most of these spreads complete without much heartburn. But other good things happen pretty frequently also. We buy a $5 spread for $3.9, say six months out when the stock was dipping. One month later it recovers and pops on good news so now our $3.9 dollar spread can be sold for $4.6. So we sell it and take a profit of 19.4% for one month. That kind of thing happens frequently WHEN THE STRATEGY IS IMPLEMENTED PROPERLY CONSIDERING MARKET TIMING AND STOCK ANALYSIS. Actually when the spreads occur in favorable market conditions, it is rare that a spread will be held till expiration.

When the market conditions are wrong we don’t enter these bull spreads. When the market turns from neutral to bearish while we are exposed, we go to work, we cut our exposure, we keep our best positions. We enter DITM bear spreads or begin to phase into them. We use our best sources of information to predict the most likely near term scenario, and we move our tweak our portfolio accordingly. But we don’t panic at every little dip, especially when the fundamentals are firmly in our favor.
 
Quote from yucca_mtn:


When the market conditions are wrong we don’t enter these bull spreads. When the market turns from neutral to bearish while we are exposed, we go to work, we cut our exposure, we keep our best positions. We enter DITM bear spreads or begin to phase into them. We use our best sources of information to predict the most likely near term scenario, and we move our tweak our portfolio accordingly. But we don’t panic at every little dip, especially when the fundamentals are firmly in our favor.
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See, here's where the problem lies. What are "wrong" conditions? Like now, when valuations *seem* high?

Or maybe when the market is dropping below its 200DMA? Bear market? Aren't there some awesome rallies in bear markets?

Yep. Whipsaw time.

Believe it or not, I lived and breathed strategies like you are doing for years. Researched, backtested, trialed, etc.

Here's the long and short IMHO - you are making things harder on yourself, because, really, if you can predict stock movement (I believe this is possible to a certain extent - otherwise, why would we be here) well enough to succesfully adjust your spreads, then you'd be a hell of a lot better off just trading the stock and/or futures.

Good luck in your trading. :cool:
 
This is a TRADER’S forum. This is an OPTIONS forum. I am not the only one around here who believes in the value of option-based strategies. Doesn’t anyone else feel a little in awe of the flexibility in investing that options give us?

No investor puts up his money unless he believes he is correct in his choices, even if his choice is to give it to a mutual fund.

Let’s say a long investor and a DITM vertical bull spread guy perform their “due diligence” and both come to the conclusion that a particular stock (ABC) will do well during the next year. It’s a $50 stock. Mr. Long buys 100 shares and invests $5000. Mr. Spread buys 3 spreads for a total of $1200. This is Feb, so he buys 3 ABC JUL07 37.5/42.5 @ 4.0.
(buys 3 ABC JUL07 37.5 calls and sells 3 ABC JUL07 42.5 calls for a value of $400 per spread X 3 spreads.)

A month later the stock drops down to $45, on news that this quarters earnings will be less than expected.. Mr. Long is down 10% of his investment, but it is just a paper loss and he has confidence the stock will recover. Mr. Spread also has confidence that the stock will recover while he watches the paper value of the spread dwindle from $4 to 3.4. (Delta is still low because it is still early in the spread, still 5 months to go.)
Mr. Spread’s spreads (sorry about that) are still $2.5 ITM, and $3.5 away from breakeven. Percentage wise Mr. Spread is down 17% but he wisely chose a longer duration spread to give the stock time for his expectations to work.

Would you consider Mr. Longs position to be safer right now than Mr. Spread’s?
If Mr. Long had only bought 30 shares of ABC stock, would you consider his investment safer?

That is only for you to decide.
 
Quote from yucca_mtn:


Let’s say a long investor and a DITM vertical bull spread guy perform their “due diligence” and both come to the conclusion that a particular stock (ABC) will do well during the next year. It’s a $50 stock. Mr. Long buys 100 shares and invests $5000. Mr. Spread buys 3 spreads for a total of $1200. This is Feb, so he buys 3 ABC JUL07 37.5/42.5 @ 4.0.
(buys 3 ABC JUL07 37.5 calls and sells 3 ABC JUL07 42.5 calls for a value of $400 per spread X 3 spreads.)

A month later the stock drops down to $45, on news that this quarters earnings will be less than expected.. Mr. Long is down 10% of his investment, but it is just a paper loss and he has confidence the stock will recover. Mr. Spread also has confidence that the stock will recover while he watches the paper value of the spread dwindle from $4 to 3.4. (Delta is still low because it is still early in the spread, still 5 months to go.)
Mr. Spread’s spreads (sorry about that) are still $2.5 ITM, and $3.5 away from breakeven. Percentage wise Mr. Spread is down 17% but he wisely chose a longer duration spread to give the stock time for his expectations to work.
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This is what my risk grapher is showing:

That spread costs $1200. Max profit is $300. So, in 6 months you can either make 25%, or lose 400% (of the max profit).

After one month, assuming constant Vol, The stock dropping to $45 would cause the total spread LOSS to be ~-$150. Yes, if held to expiry you get full value above $42.5, but the value one month from now @ $45 is negative.

Yeah, you will adjust it and trade around it and leg in/out, whatever. Still, once again, IMHO, you are banging around on those legs and getting f*cked on the b/a, etc, when you could just be in and out of that stock quite a few times over that 6 months and only pay one rather low spread each time.

Hey, I'm not telling anybody how to trade. But you are posting here looking for feedback, so here ya go!

Best to all!
 
Wayne, I really appreciate your input.

In your post earlier, I got the idea that you considered a long position safer than the DITM spread because of the ability to trade it. Well from MY previous experience I know I can't trade stocks worth a damn. I still prove it to myself on long positions I manage today. I set a stop loss, the stock hits it and immediately runs up. My timing is almost always off in the short run. I have to use covered calls on those positions as a hedge to survive.

You also indicated that even with a lot of experience you don't like options. I might have misread some of what you said.

Anyway now you post you like a better way of handling the hypothetical ABC stock using spreads. Can you share that? I did not understand what you meant.

PS - did your risk calculator really say you could by a 37.5/42.5 spread on a $45 stock 5 months out for $2.5? That sounds cheap to me.
 
I still don't see why you don't just sell the same strike deep otm put credit vertical - exact same risk profile but fewer commissions (assuming underlying moves in favor and spread expires worthless) and more liquidity.
daddy's boy
 
daddys boy.
1. I don't know how to manage that kind of spread. I will look into it though.

2. I rightly or wrongly do not consider the extra $1.50 commission to exit a spread early a burden. If I were perfect, I'm sure I would.

What would be fun and educational as hell (for me) would be for you and me to put on identical paper spreads, and compare management moves as the spread progresses.

If you or anybody else would like to play, pick a spread from the closing prices posted on yahoo at the close of a day. You do DITM vertical credit and I pick DITM vertical debit for a spread say 4 months out on a high vol crappy stock. Any takers?
 
Quote from yucca_mtn:

daddys boy.
You do DITM vertical credit and I pick DITM vertical debit for a spread say 4 months out on a high vol crappy stock. Any takers?
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I think you're a little confused here. I'm talking about SELLING the deep OTM BULL put credit vertical vs. BUYING the deep ITM BULL call debit vertical. The 2 trades are identical and management would be identical, i.e. when you close your debit vertical early you'd also close the credit vertical early - you know, put/call parity stuff.
Maybe an example would help: yhoo @ 28.56
buy yhoo apr 25/27.50 call vert for db 1.95 using natural b/a - max risk is 1.95, max credit 0.55
sell yhoo apr 25/27.50 put vert for cr of 0.6 natural b/a - max risk is1.90, max credit 0.6.
As I said, the difference between the 2 is better fills on the otm spread and if you let them run to expiry and underlying is in your favour then it (credit spread) just expires worthless. The debit spread at expiry will be autoexercised for the long and auto assigned for the short legs (assuming you're at max profit). I believe that these auto exercises and assignments will incur some commission in either one or both legs.
In summary there's no point comparing them in a real trade because management would be the same. The only advantage being the bid/ask fills and fees for the credit spread.
Best
daddy's boy
 
Quote from yucca_mtn:

daddys boy.
1. I don't know how to manage that kind of spread. I will look into it though.

2. I rightly or wrongly do not consider the extra $1.50 commission to exit a spread early a burden. If I were perfect, I'm sure I would.

What would be fun and educational as hell (for me) would be for you and me to put on identical paper spreads, and compare management moves as the spread progresses.

If you or anybody else would like to play, pick a spread from the closing prices posted on yahoo at the close of a day. You do DITM vertical credit and I pick DITM vertical debit for a spread say 4 months out on a high vol crappy stock. Any takers?
More...

yucca_mtn,

Pick up a book on options and look up Put-Call Parity and Box Spread. The options world will become a brighter place for you!

Right now, all you arguments sound like this: "I don't care if it is easier to drive the car forward, I've been driving it in reverse over the past year down a straight street and I never had any problems..."
 
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