Trading credit spread - example question

C

cmhackett

Good morning,

I'm relatively new to trading spreads, I've done a good bit with covered calls and some of your more basic options strategies though. I encountered a scenario that appears to be favorable for a spread and wanted confirmation that I wasn't screwing up my calculations. :)

While looking at the Jan 11 option chain for "C" (Citigroup) I notice that I can sell a 5.0 put for a premium of $1.77, and purchase a 4.0 put for $0.99. If I were to trade a bull put spread for 40 contracts with those prices in mind:

- If by Jan 11 "C" is trading above $5, my maximum profit (excluding comissions) is:
(40 * $1.77) - (40 * $0.99) = $7080 - $3960 = $3120.

- If by Jann 11 "C" is trading at or below $4, my maximum loss (excluding comissions) is:
($4000 {$1 diff between strikes * 40 contracts}) - ($3120 {net credit from above}) = $880.

If I've done my math correctly (and am understanding spreads right), I have a maximum potential reward of over $3000, with a maximum potential loss of less than $1000. Am I missing something? Thank you for taking the time to review this, I've been really trying to learn options over the past two years, but it's time for my reading and study to make way for actual practice. :)
 
Your numbers look ok to me although when I checked, the bid/asks were slightly different. Just remember that you buy at the ask and sell at the bid.

Just out of curiosity, why would you throw on 40 contracts right away?
That seems like quite a decent size when you are new.
Even if you are comfortable with that number, why not throw on 5-10 to start and start chiseling away with some limit orders? Perhaps try to shave a few cents off and see if you get filled.

Also, it looks like C is in a bit of a downtrend at the moment (support around $3.10-ish. You might be able to improve your spreads since the deltas for the 4 and 5 strikes will be different, so the 5 strike will gain (slightly) faster than the 4 strike.
 
Quote from cmhackett:

Good morning,

I'm relatively new to trading spreads, I've done a good bit with covered calls and some of your more basic options strategies though. I encountered a scenario that appears to be favorable for a spread and wanted confirmation that I wasn't screwing up my calculations. :)

While looking at the Jan 11 option chain for "C" (Citigroup) I notice that I can sell a 5.0 put for a premium of $1.77, and purchase a 4.0 put for $0.99. If I were to trade a bull put spread for 40 contracts with those prices in mind:

- If by Jan 11 "C" is trading above $5, my maximum profit (excluding comissions) is:
(40 * $1.77) - (40 * $0.99) = $7080 - $3960 = $3120.

- If by Jann 11 "C" is trading at or below $4, my maximum loss (excluding comissions) is:
($4000 {$1 diff between strikes * 40 contracts}) - ($3120 {net credit from above}) = $880.

If I've done my math correctly (and am understanding spreads right), I have a maximum potential reward of over $3000, with a maximum potential loss of less than $1000. Am I missing something? Thank you for taking the time to review this, I've been really trying to learn options over the past two years, but it's time for my reading and study to make way for actual practice. :)
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The risk/reward looks good, but you have to remember that the probability of the maximum profit is only 40%. If you believe that C will trade above $5 in Jan 2011, why not to buy $5 calls? They trade at 22 cents, so you can buy 40 contracts for approximately same amount of money as your example. You still have limited risk, but your profit potential is unlimited.

I personally think that a year from now, C will trade either in $2-3 range or in double digits.
 
I haven't checked the exact quotes but your calculations are correct. You are making a directional trade by doing that, as long as it is what you wish to do its fine. I say that because you are not playing the probabilities, such a trade as a negative expected return so a bad trade if you have no opinion on C. All that being said, it is so far out in time that basically anything can happen by then. That is one of the reasons why i prefer shorter time framed trades.
 
First of all, thank you to everyone who replied, I appreciate your time in helping me out.

@TheGoonior: 40 contracts isn't necessarily the figure that I would choose if I decided to enter this trade, I just used that as the example since that's what my available margin could cover - I probably wouldn't devote it all to a single trade :) The current downtrend is a good point, I'll have to spend some more time seeing how to best optimize the spread - at this point I was just looking to see if the way I was generally approaching this opportunity was good or way off.

@akivak: That's a good suggestion, but one way I could see the spread being a better choice is if the underlying only rises to say $4.50 by Jan 11 instead of $5...in that case, the put I sold is ITM for $0.50, resulting in a total loss of ($0.50 * 40 * 100) = $2000, which still would leave me with a net profit of $1120 ($3120 credit - $2000 loss), whereas if I purchased the $5 calls my entire investment of $880 would be lost...correct?

@heiasafari: I do realize that this is a directional trade and that is my goal in this case, I am generally bullish on this underlying (especially given the timeframe until expiration in this specific instance). I'm not entirely sure what you mean when you say "such a trade as a negative expected return" though, forgive me if I'm missing something obvious...
 
Quote from cmhackett:

First of all, thank you to everyone who replied, I appreciate your time in helping me out.


@akivak: That's a good suggestion, but one way I could see the spread being a better choice is if the underlying only rises to say $4.50 by Jan 11 instead of $5...in that case, the put I sold is ITM for $0.50, resulting in a total loss of ($0.50 * 40 * 100) = $2000, which still would leave me with a net profit of $1120 ($3120 credit - $2000 loss), whereas if I purchased the $5 calls my entire investment of $880 would be lost...correct?
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You are correct, but remember two things. First, a lot can happen in a year, and it is not very likely that the stock will be at 4.5. Second, if the stock goes up, the call will gain value faster than the spread.
 
Quote from cmhackett:

@heiasafari: I do realize that this is a directional trade and that is my goal in this case, I am generally bullish on this underlying (especially given the timeframe until expiration in this specific instance). I'm not entirely sure what you mean when you say "such a trade as a negative expected return" though, forgive me if I'm missing something obvious... [/B]
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It's just a probability table with confidence intervals. If you take the % of the stock being at more than 5$ on expiry multiplied by what you would gain if it were to and substract the % that its gonna end below 5$ multiplied by what you could loose you get the e(x):

ex: 3200$*0.18 - 880$*0.82 = -145,60$

Its based on stock implied volatility... That being said, like you noted there is so much time to expiry and it looses alot of precision so far away. The poster talking about the 5$ calls does have a good point if direction is what you are looking at.
 
You're playing in a $3 stock that could just as easily be bankrupt as it could be $5. This stock is gambling, you are putting on a directional trade based on hope and not fundamentals. My humble advice, If you want to play and your opinion is over $5 by Jan 2011, buy some of the 5 calls for .22 or even the 4 calls for .44. Its called leverage and a cheap bet, buy it, bank it and forget about it. If the stocks sits still, little lost, if it pops you are a king.
 
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