Vertical spread example

J

Jackson Pollack

Hello,

I have a question regarding vertical spread trades (whether bull call or bear put).

Here is hypothetical trade example with data I took from the options chain recently:

Symbol .XSP (Mini-S&P options)
Current underlying price $208.36
Expiration March 18, 2016
Bull call spread 195/200
at a cost of $3.92 (meaning $392 per spread contract)

Let's say I predict that the underlying price will go up to about $212 (meaning a profit of $212 - $208.36 = $3.64).

I'm choosing deep in the money call options (195/200) at longer term expiration (over 9 months till expiration), since I predict it could take some time for the underlying price to move up to $212.

In this case, I am long a deep in the money call option at 195 (which is about $13 in the money at start) and short a less deep in the money call option at 200 (which is about $8 in the money at start). I'm not looking to make a killing on this trade, so I limit the spread to about $5, capping any potential gains. Again, I'm only predicting price to get up to around $212.

Let's say the market actually only takes one month to get to $212, meaning that "time" value in my long call would not have decreased much, and the time value in my short call would also not have decreased much. Let's simplistically assume that no time value at all has been lost in the one month's time.

Assuming all this, my long 195 call would then be in the money $13 + $3.64 = $16.64, but then my short 200 call would the be in the money $8 + $3.64 = $11.64. That is, I would have made $3.64 on my long call, but then on my short call (which I'm obligated since I'm on the seller side), it seems I'm losing the same amount of $3.64. This doesn't seem to make any sense, and I'm sure I'm missing something here, since a bull call spread is supposed to allow me to make up to the spread amount (i.e., 5 here) at expiration.

Am I confused here? Can anyone shed light on where my logic has faltered? Will I actually make $3.64 (or $364 on the trade) in the end if I sell right when the underlying price hits $212?

Thanks in advance.
 
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The max gain on it is the $5.00 strike difference.

5.00-3.92 cost is $1.08 net profit that is fully realized at an expiration above 200 or above. Having a higher underlying price only brings it closer to max profitability as you get closer to expiration which is still $1.08.
 
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Jackson Pollack said:
Am I confused here? Can anyone shed light on where my logic has faltered? Will I actually make $3.64 (or $364 on the trade) in the end if I sell right when the underlying price hits $212?

Thanks in advance.
More...



No ...... You will lose a few pennies when commissions and the bid/ask spread is factored in. An ITM debit spread has zero upside and a potential maximum loss of the debit you paid.



:)
 
xandman said:
The max gain on it is the $5.00 strike difference.

5.00-3.92 cost is $1.08 net profit that is fully realized at an expiration above 200 or above. Having a higher underlying price only brings it closer to max profitability as you get closer to expiration which is still $1.08.
More...

xandman, thanks.

What would you recommend as an options strategy then to best capitalize or earn the $3.64 profit that results from the underlying price move from $208.36 to $212? That is, anything other than a bull call spread?

Earning just $1.08 seems too low for a much bigger $3.64 move.

Any suggestions?
 
A 1: gazillion ratio bull call spread long 208500 and short 212000 strikes. But seriously, a vertical is not a bad idea since you have the maximum move pegged.

You could buy a naked call and go farther OTM to control your delta exposure. Additionally, the flat skew is favorable to that though I am not looking that far.

Btw, your current position will produce a 20% annualized with the market above 2000. You can look at that as "core" delta and punt something else.
 
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Jackson Pollack said:
Hello,

I have a question regarding vertical spread trades (whether bull call or bear put).

Here is hypothetical trade example with data I took from the options chain recently:

Symbol .XSP (Mini-S&P options)
Current underlying price $208.36
Expiration March 18, 2016
Bull call spread 195/200
at a cost of $3.92 (meaning $392 per spread contract)

Let's say I predict that the underlying price will go up to about $212 (meaning a profit of $212 - $208.36 = $3.64).

I'm choosing deep in the money call options (195/200) at longer term expiration (over 9 months till expiration), since I predict it could take some time for the underlying price to move up to $212.

In this case, I am long a deep in the money call option at 195 (which is about $13 in the money at start) and short a less deep in the money call option at 200 (which is about $8 in the money at start). I'm not looking to make a killing on this trade, so I limit the spread to about $5, capping any potential gains. Again, I'm only predicting price to get up to around $212.

Let's say the market actually only takes one month to get to $212, meaning that "time" value in my long call would not have decreased much, and the time value in my short call would also not have decreased much. Let's simplistically assume that no time value at all has been lost in the one month's time.

Assuming all this, my long 195 call would then be in the money $13 + $3.64 = $16.64, but then my short 200 call would the be in the money $8 + $3.64 = $11.64. That is, I would have made $3.64 on my long call, but then on my short call (which I'm obligated since I'm on the seller side), it seems I'm losing the same amount of $3.64. This doesn't seem to make any sense, and I'm sure I'm missing something here, since a bull call spread is supposed to allow me to make up to the spread amount (i.e., 5 here) at expiration.

Am I confused here? Can anyone shed light on where my logic has faltered? Will I actually make $3.64 (or $364 on the trade) in the end if I sell right when the underlying price hits $212?

Thanks in advance.
More...

If you bought a DITM call, 9 months out, I would just ride that and each time an earnings came around, the day before, buy, in that earnings month, a cheap OTM put to protect what you have.
If the underlyer heads south, say on an earnings miss, your put heads north very quickly, including expanding vol.
If the underlyer heads north, well, you move closer to your projected lucrative exit on the call and you lose what you paid for the put, which should have been peanuts.
 
He is trading the index.

However, that is one way to trading options on a stock. Just not fond of buying an option at the seasonal peak of IV. Additionally, an earnings trade is a game within a game with unpredictable results for most (But especially, me).

If I can successfully do earnings vol, I would gladly overlay that on a bigger strategy.
 
xandman said:
He is trading the index.

However, that is one way to trading options on a stock. Just not fond of buying an option at the seasonal peak of IV. Additionally, an earnings trade is a game within a game with unpredictable results for most (But especially, me).

If I can successfully do earnings vol, I would gladly overlay that on a bigger strategy.
More...

thanks for all the input.

so that I'm getting all of this straight, let's say I do the following trade instead:

Symbol .XSP (Mini-S&P options)
Current underlying price $208
Expiration March 18, 2016
Bull call spread LONG 195 call (at $18.08) and SHORT 208 call (at $8.52)
debit cost = $9.56 (meaning $956 per spread contract)

My max profit would be 208-195=13 minus 9.56 = $3.44 (meaning $344 per spread contract)

Let's say I predict that the underlying price will go up to exactly $212.

AT EXPIRATION:
At expiration, so long as the underlying price is above 208 (the strike of the SHORT call) ($212 is above 208, great), then both the LONG and SHORT calls would be ITM, and thus both are exercisable, and so closing the position would net me the max profit of $344. Great.

WAY BEFORE EXPIRATION:
However, let's say just 1 day after my trade, the underlying price jumps to $212 (a $4 jump). Not taking into account any crazy volatility change when the underlying price jumps from $208 to $212, this means no real change in time value portion of the premiums for the LONG or SHORT calls has occurred. Thus, theoretically, the premium for the 195 call would be $18.08 + 4 = $22.08. The premium for the 208 call would be $8.52 + 4 = $12.52. So now my question is that, it's not close to expiration yet (it's only been 1 day into the trade, and I hit my target of $212). What would my profit be? Both the LONG 195 and SHORT 208 calls are ITM and so are immediately exercisable, but they both went up $4 in intrinsic value equally. Can I make the max profit of $344 at any time prior to expiration here?


I might add that the reason I'm looking at vertical spreads is that I can lower the cost of the trade by collecting a premium for the call I short. I could instead buy a naked call and not have to worry about the complexity of a spread, but it would be more expensive and require more of my capital to be locked up. Am I trying to achieve the impossible or unreasonable here, seeking close to max profit of $3.44 on the spread example above, way before expiration?
 
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Jackson Pollack ...... I hate to be a wet blanket BUT buying an ITM debit spread will not give you a 20% annualized return as xandman stated. It will give you 0% - you are risking your entire debit for a 0% return.


:)
 
You will, most likely, not realize the max profit value until expiration.

Your position is now earning Theta. So, much like an option seller, you are waiting for maximum profitability.

Not sure what OTM is saying.
 
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