Trading with Spreads - Looking for Advice

Quote from Put_Master:

Well, as long as you asked, I'll throw in my 2 cents.
Just a few months ago, between mid May and mid June, when the stock was formings a base of support in the $32 area, you were not bullish or interested in a trade.
When it then formed another base of support in the $34 area, you were still not bullish or interested in a trade.
Now that the stock has risen almost 30% from that $32 area,.... now you are bullish and interested in a trade???
6 month chart below:
http://finance.yahoo.com/q/bc?s=JPM&t=6m&l=on&z=l&q=b&c=

While the credit and annualized % return for the trade looks good, the "probability" of actually keeping that profit, doesn't look quite as good.
WHY?
You are investing high, as the stock has already had a nice run,.... your otm safety cushion is only about 2.5%,.... since it's a spread I'm assuming you don't want to consider buying the stock, and probably can't buy the stock if it trades below your bullish strike, which means you plan to close the trade for a loss, if the stock drops more than 2%,.... you are using a 4 point strike gap, which means you won't get as much benefit neutralizing a drop in stock price and/or a spike in VIX, if/when closing your spread, as a more narrow strike gap spread would offer,.... JPM earnings are reported one week before the trade expires. That could be a stressful day and subsequent volatile week, and so on...
Like I said, the credit looks good. But I'm not as impressed with the "probability" of actually keeping the profit.

There are plenty of positive issues about the trade as well. But you already know them. And simply having a cheer leader tell you what you want to hear, doesn't really add anything of value to your analysis of a potential trade.

One last issue. You mentioned the spread trade as having a "limited risk".
In spread lingo, that is "code" for,.... "I would be on excessive margin leverage if I considered buying the stock if put to me. So I will be forced to close the trade for no more than a pre-set maximum loss, if the stock drops a penny or more under my bullish strike."
And if all your investment cash is used to trade spreads, and they all experience a sig drop, then that "limited risk", is only limited to the size of your entire account. That being, you can only lose up to 100% of your account. Not any more.
Why?
Because 98% of spreads are using a significant amount of margin leverage.
And the higher the strikes are that you use, and/or the more narrow your spread gap, the higher the margin leverage you are using.
And the more margin you are on, the more you are at risk of that.... "limited loss"
Just my 2 cents.
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Thank you, I wanted someone to tell me what was wrong with it. I agree that JPM is high right now but I was looking at an example of the first that popped ino my head as far as a stock.

I clearly need to familiarize myself with the greeks.

The stock couldn't be put to me there though, just exercise and sell in one action the $38 if it's ITM at expiration, right? Of course the stock could fall below $38 and I'd take a hefty loss. Also I wasn't so much concerned with the earnings release, I wouldn't take that trade, but the strategy itself.
 
Trader198,
Time decay is either working for you every single day, if you are selling an option, or it is working against you every single day, if you are buying an option.
If your time frame (contract) is long, it may only be working for or against you a fraction of a fraction of a penny every day, but it is still ticking away.

While theta may not have as much impact as a large % move in a stock, it's impact still must be considered in the context of the trade.
WHY?
Because you have no idea "if" the stock is going to have a big % move.
And if there is going to be a big move, you don't know "when" the move will occur. Will the move will come early or late in the contract?
And will the move come in slow increments, or all at once?
And will that large % move hold, or quickly fall back, due to others taking a profit before you do?

While the impact theta has on your trade will be more relevant and more noticeable when you are closing down a trade vs holding to expiration, you should not assume you will never close down a trade early. It's during those tmes when issues like IV and theta can have a surprisingly positive or negative affect on your trade and account value.
It's always better to anticipate and plan for those special moments, than to be surprised by them.
 
Quote from kjones5159:

Thank you, I wanted someone to tell me what was wrong with it. I agree that JPM is high right now but I was looking at an example of the first that popped ino my head as far as a stock.
I clearly need to familiarize myself with the greeks.
The stock couldn't be put to me there though, just exercise and sell in one action the $38 if it's ITM at expiration, right? Of course the stock could fall below $38 and I'd take a hefty loss. Also I wasn't so much concerned with the earnings release, I wouldn't take that trade, but the strategy itself.
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If you close the $38, you will then either be naked the $42 put, or you will own the stock at a price of $42.
You can only be naked the $42, if your account has been approved for level 3 trading.
And you can only consider owning the stock, if you have not sold too many contracts.

For example, assume you have a $40,000 account and invested all your money in either one or multiple 4 point spread trades, with a strike of $42.
If all those naked puts were put to you, you would need $420,000 to buy all those shares.
That is 10 times your account value. Therefore, you obviously can NOT buy the stock

Thus, if the stock is trading BELOW your $42 strike, you must close the trade for a loss. How big a loss will depend on how deep below your $42 price it is trading, and how much time premium remains in the trade, at the time you close it.
If you wait until the stock is at $38 or less, your account will be 100% wiped out,.... minus your credit received, and minus any time premium remaining.
The longer you wait to close a deteriorating trade, the less time premium will be remaining. Thus the larger your loss.

As for the issue of the earning release,.... you should be aware of the earnings release date, of every single stock you trade options on.
Even if your contract ends a few days before earnings are released, the company may issue a warnings a few days or weeks early.
That announcement could have a sig affect on your trade, your subsequent trading choices, and your account value

Remember, if you are engaged in a spread contract, you are most likely using excessive margin leverage.
In the example I used above, your account is leveraged 10 times it's actual value.
When using that much leverage, you lose the option (choice) to consider buying your stock. All you can consider doing is closing for a loss.
At that point, the only control you have is "WHEN" you close your trade. And the timing of that will determine how large your loss will be.
 
Quote from Put_Master:

If you close the $38, you will then either be naked the $42 put, or you will own the stock at a price of $42.
You can only be naked the $42, if your account has been approved for level 3 trading.
And you can only consider owning the stock, if you have not sold too many contracts.

For example, assume you have a $40,000 account and invested all your money in either one or multiple 4 point spread trades, with a strike of $42.
If all those naked puts were put to you, you would need $420,000 to buy all those shares.
That is 10 times your account value. Therefore, you obviously can NOT buy the stock

Thus, if the stock is trading BELOW your $42 strike, you must close the trade for a loss. How big a loss will depend on how deep below your $42 price it is trading, and how much time premium remains in the trade, at the time you close it.
If you wait until the stock is at $38 or less, your account will be 100% wiped out,.... minus your credit received, and minus any time premium remaining.
The longer you wait to close a deteriorating trade, the less time premium remaining. Thus the larger your loss.

As for the issue of the earning release,.... you should be aware of the earnings release date, of every single stock you trade options on.
Even if your contract ends a few days before earnings are released, the company may issue a warnings a few days or weeks early.
That announcement could have a sig affect on your trade, your subsequent trading choices, and your account value

Remember, if you are engaged in a spread contract, you are most likely using excessive margin leverage.
In the example I used above, your account is leveraged 10 times it's actual value.
When using that much leverage, you lose the option (choice) of buying your stock. All you can consider doing is closing for a loss.
At that point, the only control you have is "WHEN" you close your trade. And the timing of that will determines how large your loss will be.
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I'm talking about a bull CALL spread, no puts involved, with a basis of holding until expiration.

Buy ITM call, sell OTM call, a debit spread that starts in the green. I'd be buying the $38 contract ITM, thereby giving me rights to buy stock at $38, and since ITM are priced so that you'd break even (or be very close to it) if buying and exercising it at any one point in time, my thinking is to shave some cost off of it by selling an OTM call. No risk of assignment.
 
]I'm talking about a bull CALL spread, no puts involved, with a basis of holding until expiration.

Buy ITM call, sell OTM call, a debit spread that starts in the green. I'd be buying the $38 contract ITM, thereby giving me rights to buy stock at $38, and since ITM are priced so that you'd break even (or be very close to it) if buying and exercising it at any one point in time, my thinking is to shave some cost off of it by selling an OTM call.
 
Quote from kjones5159:

I'm talking about a bull CALL spread, no puts involved, with a basis of holding until expiration.

Buy ITM call, sell OTM call, a debit spread that starts in the green. I'd be buying the $38 contract ITM, thereby giving me rights to buy stock at $38, and since ITM are priced so that you'd break even (or be very close to it) if buying and exercising it at any one point in time, my thinking is to shave some cost off of it by selling an OTM call. No risk of assignment.
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In my example of a $40,000 account, you may have the theoretical right to buy the stock at $38, but you do NOT have the funds to do so.
Just as in the selling of a put, you would need $380,000 to buy the 100 contracts. Thus, you would need to close the trade before the contract expired, when the stock traded between $38 and $42.
The higher it traded when you closed it, the higher your profit. Up to your pre set max gain.
So it really doesn't matter if you initiated the bullish spread trade via puts or calls.
Either way, (bullish put or bullish call spread), you can NOT buy and own the stock per my $40,000 account example.
Either way, if you are using your entire $40,000 account, then you are using massive margin leverage of around 10:1. Thus you can not buy the stock.

If you are only selling/buying up to 10 contracts, that is a different issue.
But that means you would only be using 10% of your account funds.
If you use all your funds for spread trades, you can NOT buy 90% or more of the stock(s) you are investing in.
You MUST close the trade before exp.

If you used a lot more than 10% of your account funds and don't close your call spread trade, your broker will do it for you on exp day.
HOWEVER, if the company is too busy to get to your account, you will have to HOPE the stock does not open monday morning trading down, or not only will your account be potentially 100% wiped out,.... but you may actually owe the company money a well.
Thus, the trade must be closed, unless you have the funds to buy all your contracts.
In the case of JPM, you need $3,800 for every single contract you initiated, for every contract you want to buy.
If you sold 100 contracts with your $40,000 account, you would need $380,000 to buy all your call spreads at $38.
And keep in mind, you would have already paid cash up front, to initiate the bullish call spread trade.
 
<<< Prob JPM below 38 = 65% ; P/L = -$251
Prob JPM Greater then 42 = 8% ; P/L = $149
Prob between 38 and 42 = 1 - (.65+ .8) = 27% ; P/L = -51 (average)Probability wise a bad bet... unless you have information that the future for JPM is bullish. I don't get that from the chart: >>>


Oldnemesis, we are in agreement the JPM potential trade is a low probabiligty one.
However, we differ on why.
You are basing it on a one size fits all, generic prob calculator formula. I'm basing it on common sense.
The problem I have with these generic probability calculators is, they don't take issues such as tech support into account.

For example, whether JPM is trading at it's all time high, or trading at strong tech support, or whether the strike being discussed was at strong tech support,... is all irrelevent according to the formula.
Either way, the probability % answer the calculator spits out will be the same.

However, in the real world, if a stock is currently trading at L-T tech support, and the desired otm strike is at an even lower L-T tech support area,.... that trade will have a higher prob of remaining otm, than a stock not currently trading at tech support, and with no tech support seen any where close to the desired strike.
And yet, the prob calc will evaluate both trades as being equally likely to be successful.

Tech support is 100% irrelevant to all probability calculators.
For that and other reasons, I totally ignore all those one size fits all generic probability calculators.
I prefer to use other criteria, such as common sense and experience, to evaluate a trades likelihood of being successful.
 
I was under the impression that I would exercise the option and "buy" the shares, but simultaneously sell them at the market/higher strike (for a spread) instead of taking posession of the shares outright. Point here being that if the sold option expires worthless, the profit of the trade is the premium recieved subtracted from the intrinsic value of the ITM option, for this to happen the spread is held until expiration so as not to be naked. Anyway, I've pretty much answered my own question.
 
Quote from kjones5159:

I was under the impression that I would exercise the option and "buy" the shares, but simultaneously sell them at the market/higher strike (for a spread) instead of taking posession of the shares outright. Point here being that if the sold option expires worthless, the profit of the trade is the premium recieved subtracted from the intrinsic value of the ITM option, for this to happen the spread is held until expiration so as not to be naked. Anyway, I've pretty much answered my own question.
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I'll let others answer the question, as I'm more used to thinking in terms of puts vs calls, and i don't want to mislead you.
But it is my understanding that whether or not you have a profit will depend on where the stock is trading at the time you close the trade.
You may have have a total, a partial, or no profit at all.
Didn't you pay money up front to initiate the trade?

Also, you talked about the trade giving you the right to buy the stock at $38.
That's why I assumed you wanted to be able to consider doing so as an option (choice).
Hence, my point being you can NOT buy the shares, since you don't have enough cash in the account, So you must close the trade before exp, and hope you are closing for a profit.... which will depend on where the stock is trading.
Yes, you can simultaneously buy and sell the shares when exercising the option. Assuming the contract has not expired.
 
Bottom line,... whether one wants to initiate a bullish put spread or a bullish call spread, there is really no advantage of selecting one over the other.
Just depends on which structure you prefer to deal with.
Both will have the same cash at risk, both will have the same income generating opportunities, both will have the same risk/reward, both will have the same probability of being successful, ect.....
There may be times one style is easier to get a fill on than the other. But for the most part, it boils down to a preference of which way you are more comfortable, in terms of thinking about the trade.
I'm more used to selliing put spreads, and thinking about spreads in that "context", while others may be more used to thinking about spreads in the "context" of calls.
Just a personal preference.
No advantage/disadvantage to trading one way vs the other.
 
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