Add training workflow, datasets, and runbook
This commit is contained in:
@@ -0,0 +1,209 @@
|
||||
CHAPTER 9
|
||||
Vertical Spreads
|
||||
Risk—it is the focal point around which all trading revolves. It may seem as if profit should be occupying this seat, as most important to trading options, but without risk, there would be no profit! As traders, we must always look for ways to mitigate, eliminate, preempt, and simply avoid as much risk as possible in our pursuit of success without diluting opportunity. Risk must be controlled. Trading vertical spreads takes us one step further in this quest.
|
||||
The basic strategies discussed in Chapters 4 and 5 have strengths when compared with pure linear trading in the equity markets. But they have weaknesses, too. Consider the covered call, one of the most popular option strategies.
|
||||
A covered call is best used as an augmentation to an investment plan. It can be used to generate income on an investment holding, as an entrance strategy into a stock, or as an exit strategy out of a stock. But from a trading perspective, one can often find better ways to trade such a forecast.
|
||||
If the forecast on a stock is neutral to moderately bullish, accepting the risk of stock ownership is often unwise. There is always the chance that the stock could collapse. In many cases, this is an unreasonable risk to assume.
|
||||
To some extent, we can make the same case for the long call, short put, naked call, and the like. In certain scenarios, each of these basic strategies is accompanied with unwanted risks that serve no beneficial purpose to the trader but can potentially cause harm. In many situations, a vertical spread is a better alternative to these basic spreads. Vertical spreads allow a trader to limit potential directional risk, limit theta and vega risk, free up margin, and generally manage capital more efficiently.
|
||||
Vertical Spreads
|
||||
Vertical spreads involve buying one option and selling another. Both are on the same underlying and expire the same month, and both are either calls or puts. The difference is in the strike prices of the two options. One is higher than the other, hence the name
|
||||
vertical spread
|
||||
. There are four vertical spreads: bull call spread, bear call spread, bear put spread, and bull put spread. These four spreads can be sliced and diced into categories a number of ways: call spreads and put spreads, bull spreads and bear spreads, debit spreads and credit spreads. There is overlap among the four verticals in how and when they are used. The end of this chapter will discuss how the spreads are interrelated.
|
||||
Bull Call Spread
|
||||
A bull call spread is a long call combined with a short call that has a higher strike price. Both calls are on the same underlying and share the same expiration month. Because the purchased call has a lower strike price, it costs more than the call being sold. Establishing the trade results in a debit to the trader’s account. Because of this debit, it’s called a debit spread.
|
||||
Below is an example of a bull call spread on Apple Inc. (AAPL):
|
||||
In this example, Apple is trading around $391. With 40 days until February expiration, the trader buys the 395–405 call spread for a net debit of $4.40, or $440 in actual cash. Or one could simply say the trader paid $4.40 for the 395–405 call.
|
||||
Consider the possible outcomes if the spread is held until expiration.
|
||||
Exhibit 9.1
|
||||
shows an at-expiration diagram of the bull call spread.
|
||||
EXHIBIT 9.1
|
||||
AAPL bull call spread.
|
||||
Before discussing the greeks, consider the bull call spread from an at-expiration perspective. Unlike the long call, which has two possible outcomes at expiration—above or below the strike—this spread has three possibilities: below both strikes, between the strikes, or above both strikes.
|
||||
In this example, if Apple is below $395 at expiration, both calls expire worthless. The rights and obligations of the options are gone, as is the cash spent on the trade. In this case, the entire debit of $4.40 is lost.
|
||||
If Apple is between the strikes at expiration, the 405-strike call expires worthless. The trader is long stock at an effective price of $399.40. This is the $395-strike price at which the stock would be purchased if the call is exercised, plus the $4.40 premium spent on the spread. The break-even price of the trade is $399.40. If Apple is above $399.40 at expiration, the trade is profitable; below $399.40, it is a loser. The aptly named bull call spread requires the stock to rise to reach its profit potential. But unlike an outright long call, profits are capped with the spread.
|
||||
If Apple is above $405 at expiration, both calls are in-the-money (ITM). If the 395-strike calls are exercised, the trader buys 100 shares of Apple at $395 and these shares, in turn, would be sold at $405 when the 405-strike calls are assigned, for a $10 gain per share. Subtract from that $10 the $4.40 debit spent on the trade and the net profit is $5.60 per share.
|
||||
There are some other differences between the 395–405 call spread and the outright purchase of the 395 call. The absolute risk is lower. To buy the 395-strike call costs 14.60, versus 4.40 for the spread—a big difference. Because the debit is lower, the margin for the spread is lower at most option-friendly brokers, as well.
|
||||
If we dig a little deeper, we find some other differences between the bull call spread and the outright call. Long options are haunted by the specter of time. Because the spread involves both a long and a short option, the time-decay risk is lower than that associated with owning an option outright. Implied volatility (IV) risk is lower, too.
|
||||
Exhibit 9.2
|
||||
compares the greeks of the long 395 call with those of the 395–405 call spread.
|
||||
EXHIBIT 9.2
|
||||
Apple call versus bull call spread (Apple @ $391).
|
||||
395 Call
|
||||
395–405 Call
|
||||
Delta
|
||||
0.484
|
||||
0.100
|
||||
Gamma
|
||||
0.0097
|
||||
0.0001
|
||||
Theta
|
||||
−0.208
|
||||
−0.014
|
||||
Vega
|
||||
0.513
|
||||
0.020
|
||||
The positive deltas indicate that both positions are bullish, but the outright call has a higher delta. Some of the 395 call’s directional sensitivity is lost when the 405 call is sold to make a spread. The negative delta of the 405 call somewhat offsets the positive delta of the 395 call. The spread delta is only about 20 percent of the outright call’s delta. But for a trader wanting to focus on trading direction, the smaller delta can be a small sacrifice for the benefit of significantly reduced theta and vega. Theta spread’s risk is about 7 percent that of the outright. The spread’s vega risk is also less than 4 percent that of the outright 395 call. With the bull call spread, a trader can spread off much of the exposure to the unwanted risks and maintain a disproportionately higher greeks in the wanted exposure (delta).
|
||||
These relationships change as the underlying moves higher. Remember, at-the-money (ATM) options have the greatest sensitivity to theta and vega. With Apple sitting at around the long strike, gamma and vega have their greatest positive value, and theta has its most negative value.
|
||||
Exhibit 9.3
|
||||
shows the spread greeks given other underlying prices.
|
||||
EXHIBIT 9.3
|
||||
AAPL 395–405 bull call spread.
|
||||
As the stock moves higher toward the 405 strike, the 395 call begins to move away from being at-the-money, and the 405 call moves toward being at-the-money. The at-the-money is the dominant strike when it comes to the characteristics of the spread greeks. Note the greeks position when the underlying is directly between the two strike prices: The long call has ceased to be the dominant influence on these metrics. Both calls influence the analytics pretty evenly. The time-decay risk has been entirely spread off. The volatility risk is mostly spread off. Gamma remains a minimal concern. When the greeks of the two calls balance each other, the result is a directional play.
|
||||
As AAPL continues to move closer to the 405-strike, it becomes the at-the-money option, with the dominant greeks. The gamma, theta, and vega of the 405 call outweigh those of the ITM 395 call. Vega is more negative. Positive theta now benefits the trade. The net gamma of the spread has turned negative. Because of the negative gamma, the delta has become smaller than it was when the stock was at $400. This means that the benefit of subsequent upward moves in the stock begins to wane. Recall that there is a maximum profit threshold with a vertical spread. As the stock rises beyond $405, negative gamma makes the delta smaller and time decay becomes less beneficial. But at this point, the delta has done its work for the trader who bought this spread when the stock was trading around $395. The average delta on a move in the stock from $395 to $405 is about 0.10 in this case.
|
||||
When the stock is at the 405 strike, the characteristics of the trade are much different than they are when the stock is at the 395 strike. Instead of needing movement upward in the direction of the delta to combat the time decay of the long calls, the position can now sit tight at the short strike and reap the benefits of option decay. The key with this spread, and with all vertical spreads, is that the stock needs to move in the direction of the delta to the short strike.
|
||||
Strengths and Limitations
|
||||
There are many instances when a bull call spread is superior to other bullish strategies, such as a long call, and there are times when it isn’t. Traders must consider both price and time.
|
||||
A bull call spread will always be cheaper than the outright call purchase. That’s because the cost of the long-call portion of the spread is partially offset by the premium of the higher-strike short call. Spending less for the same exposure is always a better choice, but the exposure of the vertical is not exactly the same as that of the long call. The most obvious trade-off is the fact that profit is limited. For smaller moves—up to the price of the short strike—vertical spreads tend to be better trades than outright call purchases. Beyond the strike? Not so much.
|
||||
But time is a trade-off, too. There have been countless times that I have talked with new traders who bought a call because they thought the stock was going up. They were right and still lost money. As the adage goes, timing is everything. The more time that passes, the more advantageous the lower-theta vertical spread becomes. When held until expiration, a vertical spread can be a better trade than an outright call in terms of percentage profit.
|
||||
In the previous example, when Apple is at $391 with 40 days until expiration, the 395 call is worth 14.60 and the spread is worth 4.40. If Apple were to rise to be trading at $405 at expiration, the call rises to be worth 10, for a loss of 4.60 on the 14.60 debit paid. The spread also is worth 10. It yields a gain of about 127 percent on the initial $4.40 per share debit.
|
||||
But look at this same trade if the move occurs before expiration. If Apple rallies to $405 after only a couple weeks, the outcome is much different. With four weeks still left until expiration, the 395 call is worth 19.85 with the underlying at $405. That’s a 36 percent gain on the 14.60. The spread is worth 5.70. That’s a 30 percent gain. The vertical spread must be held until expiration to reap the full benefits, which it accomplishes through erosion of the short option.
|
||||
The long-call-only play (with a significantly larger negative theta) is punished severely by time passing. The long call benefits more from a quick move in the underlying. And of course, if the stock were to rise to a price greater than $405, in a short amount of time—the best of both worlds for the outright call—the outright long 395 call would be emphatically superior to the spread.
|
||||
Bear Call Spread
|
||||
The next type of vertical spread is called a
|
||||
bear call spread
|
||||
. A bear call spread is a short call combined with a long call that has a higher strike price. Both calls are on the same underlying and share the same expiration month. In this case, the call being sold is the option of higher value. This call spread results in a net credit when the trade is put on and, therefore, is called a credit spread.
|
||||
The bull call spread and the bear call spread are two sides of the same coin. The difference is that with the bull call spread, one is buying the call spread, and with the bear call spread, one is selling the call spread. An example of a bear call spread can be shown using the same trade used earlier.
|
||||
Here we are selling one AAPL February (40-day) 395 call at 14.60 and buying the 405 call at 10.20. We are selling the 395–405 call at $4.40 per share, or $440.
|
||||
Exhibit 9.4
|
||||
is an at-expiration diagram of the trade.
|
||||
EXHIBIT 9.4
|
||||
Apple bear call spread.
|
||||
The same three at-expiration outcomes are possible here as with the bull call spread: the stock can be above both strikes, between both strikes, or below both strikes. If the stock is below both strikes at expiration, both calls will expire worthless. The rights and obligations cease to exist. In this case, the entire credit of $440 is profit.
|
||||
If AAPL is between the two strike prices at expiration, the 395-strike call will be in-the-money. The short call will get assigned and result in a short stock position at expiration. The break-even price falls at $399.40—the short strike plus the $4.40 net premium. This is the price at which the stock will effectively be sold if assignment occurs.
|
||||
If Apple is above both strikes at expiration, it means both calls are in-the-money. Stock is sold at $395 because of assignment and bought back at $405 through exercise. This leads to a loss of $10 per share on the negative scalp. Factoring in the $4.40-per-share credit makes the net loss only $5.60 per share with AAPL above $405 at February expiration.
|
||||
Just as the at-expiration diagram is the same but reversed, the greeks for this call spread will be similar to those in the bull call spread example except for the positive and negative signs. See
|
||||
Exhibit 9.5
|
||||
.
|
||||
EXHIBIT 9.5
|
||||
Apple 395–405 bear call spread.
|
||||
A credit spread is commonly traded as an income-generating strategy. The idea is simple: sell the option closer-to-the-money and buy the more out-of-the-money (OTM) option—that is, sell volatility—and profit from nonmovement (above a certain point). In this example, with Apple at $391, a neutral to slightly bearish trader would think about selling this spread at 4.40 in hopes that the stock will remain below $395 until expiration. The best-case scenario is that the stock is below $395 at expiration and both options expire, resulting in a $4.40-per-share profit.
|
||||
The strategy profits as long as Apple is under its break-even price, $399.40, at expiration. But this is not so much a bearish strategy as it is a nonbullish strategy. The maximum gain with a credit spread is the premium received, in this case $4.40 per share. Traders who thought AAPL was going to decline sharply would short it or buy a put. If they thought it would rise sharply, they’d use another strategy.
|
||||
From a greek perspective, when the trade is executed it’s very close to its highest theta price point—the 395 short strike price. This position theoretically collects $0.90 a day with Apple at around $395. As time passes, that theta rises. The key is that the stock remains at around $395 until the short option is just about worthless. The name of the game is sit and wait.
|
||||
Although the delta is negative, traders trading this spread to generate income want the spread to expire worthless so they can pocket the $4.40 per share. If Apple declines, profits will be made on delta, and theta profits will be foregone later. All that matters is the break-even point. Essentially, the idea is to sell a naked call with a maximum potential loss. Sell the 395s and buy the 405s for protection.
|
||||
If the underlying decreases enough in the short term and significant profits from delta materialize, it is logical to consider closing the spread early. But it often makes more sense to close part of the spread. Consider that the 405-strike call is farther out-of-the-money and will lose its value before the 395 call.
|
||||
Say that after two weeks a big downward move occurs. Apple is trading at $325 a share; the 405s are 0.05 bid at 0.10, and the 395s are 0.50 bid at 0.55. At this point, the lion’s share of the profits can be taken early. A trader can do so by closing only the 395 calls. Closing the 395s to eliminate the risk of negative delta and gamma makes sense. But does it make sense to close the 405s for 0.05? Usually not. Recouping this residual value accomplishes little. It makes more sense to leave them in your position in case the stock rebounds. If the stock proves it can move down $70; it can certainly move up $70. Because the majority of the profits were taken on the 395 calls, holding on to the 405s is like getting paid to own calls. In scenarios where a big move occurs and most of the profits can be taken early, it’s often best to hold the long calls, just in case. It’s a win-win situation.
|
||||
Credit and Debit Spread Similarities
|
||||
The credit call spread and the debit call spread appear to be exactly opposite in every respect. Many novice traders perceive credit spreads to be fundamentally different from debit spreads. That is not necessarily so. Closer study reveals that these two are not so different after all.
|
||||
What if Apple’s stock price was higher when the trade was put on? What if the stock was at $405? First, the spread would have had more value. The 395 and 405 calls would both be worth more. A trader could have sold the spread for a $5.65-per-share credit. The at-expiration diagram would look almost the same. See
|
||||
Exhibit 9.6
|
||||
.
|
||||
EXHIBIT 9.6
|
||||
Apple bear call spread initiated with Apple at $405.
|
||||
Because the net premium is much higher in this example, the maximum gain is more—it is $5.65 per share. The breakeven is $400.65. The price points on the at-expiration diagram, however, have nothing to do with the greeks. The analytics from
|
||||
Exhibit 9.5
|
||||
are the same either way.
|
||||
The motivation for a trader selling this call spread, which has both options in-the-money, is different from that for the typical income generator. When the spread is sold in this context, the trader is buying volatility. Long gamma, long vega, negative theta. The trader here has a trade more like the one in the bull call spread example—except that instead of needing a rally, the trader needs a rout. The only difference is that the bull call spread has a bullish delta, and the bear call spread has a bearish delta.
|
||||
Bear Put Spread
|
||||
There is another way to take a bearish stance with vertical spreads: the bear put spread. A bear put spread is a long put plus a short put that has a lower strike price. Both puts are on the same underlying and share the same expiration month. This spread, however, is a debit spread because the more expensive option is being purchased.
|
||||
Imagine that a stock has had a good run-up in price. The chart shows a steady march higher over the past couple of months. A study of technical analysis, though, shows that the run-up may be pausing for breath. An oscillator, such as slow stochastics, in combination with the relative strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.
|
||||
For traders looking for a small pullback, a bear put spread can be an excellent strategy. The goal is to see the stock drift down to the short strike. So, like the other members of the vertical spread family, strike selection is important.
|
||||
Let’s look at an example of ExxonMobil (XOM). After the stock has rallied over a two-month period to $80.55, a trader believes there will be a short-term temporary pullback to $75. Instead of buying the June 80 puts for 1.75, the trader can buy the 75–80 put spread of the same month for 1.30 because the 75 put can be sold for 0.45.
|
||||
1
|
||||
In this example, the June put has 40 days until expiration.
|
||||
Exhibit 9.7
|
||||
illustrates the payout at expiration.
|
||||
EXHIBIT 9.7
|
||||
ExxonMobil bear put spread.
|
||||
If the trader is wrong and ExxonMobil is still above 80 at expiry, both puts expire and the 1.30 premium is lost. If ExxonMobil is between the two strikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are OTM and expire. The net effect is short stock at an effective price of $78.70. The effective sale price is found by taking the price at which the short stock is established when the puts are exercised—$80—minus the net 1.30 paid for the spread. This is the spread’s breakeven at expiration.
|
||||
If the trader is right and ExxonMobil is below both strikes at expiration, both puts are ITM, and the result is a 3.70 profit and no position. Why a 3.70 profit? The 80 puts are exercised, making the trader short at $80, and the 75 puts are assigned, so the short is bought back at $75 for a positive stock scalp of $5. Including the 1.30 debit for the spread in the profit and loss (P&(L)), the net profit is $3.70 per share when the stock is below both strikes at expiration.
|
||||
This is a bearish trade. But is the bear put spread necessarily a better trade than buying an outright ATM put? No. The at-expiration diagram makes this clear. Profits are limited to $3.70 per share. This is an important difference. But because in this particular example, the trader expects the stock to retrace only to around $75, the benefits of lower cost and lower theta and vega risk can be well worth the trade-off of limited profit. The trader’s objectives are met more efficiently by buying the spread. The goal is to profit from the delta move down from $80 to $75.
|
||||
Exhibit 9.8
|
||||
shows the differences between the greeks of the outright put and the spread when the trade is put on with ExxonMobil at $80.55.
|
||||
EXHIBIT 9.8
|
||||
ExxonMobil put vs. bear put spread (ExxonMobil @ $80.55).
|
||||
80 Put
|
||||
75–80 Put
|
||||
Delta
|
||||
−0.445
|
||||
−0.300
|
||||
Gamma
|
||||
+0.080
|
||||
+0.041
|
||||
Theta
|
||||
−0.018
|
||||
−0.006
|
||||
Vega
|
||||
+0.110
|
||||
+0.046
|
||||
As in the call-spread examples discussed previously, the spread delta is smaller than the outright put’s. It appears ironic that the spread with the smaller delta is a better trade in this situation, considering that the intent is to profit from direction. But it is the relative differences in the greeks besides delta that make the spread worthwhile given the trader’s goal. Gamma, theta, and vega are proportionately much smaller than the delta in the spread than in the outright put. While the spread’s delta is two thirds that of the put, its gamma is half, its theta one third, and its vega around 42 percent of the put’s.
|
||||
Retracements such as the one called for by the trader in this example can happen fast, sometimes over the course of a week or two. It’s not necessarily bad if this move occurs quickly. If ExxonMobil drops by $5 right away, the short delta will make the position profitable.
|
||||
Exhibit 9.9
|
||||
shows how the spread position changes as the stock declines from $80 to $75.
|
||||
EXHIBIT 9.9
|
||||
75–80 bear put spread as ExxonMobil declines.
|
||||
The delta of this trade remains negative throughout the stock’s descent to $75. Assuming the $5 drop occurs in one day, a delta averaging around −0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36 times $5 times 100). This is still a far cry from the spread’s $3.70 potential profit. Although the stock is at $75, the maximum profit potential has yet to be reached, and it won’t be until expiration. How does the rest of the profit materialize? Time decay.
|
||||
The price the trader wants the stock to reach is $75, but the assumption here is that the move happens very fast. The trade went from being a long-volatility play—long gamma and vega—to a short-vol play: short gamma and vega. The trader wanted movement when the stock was at $80 and wants no movement when the stock is at $75. When the trade changes characteristics by moving from one strike to another, the trader has to reconsider the stock’s outlook. The question is: if I didn’t have this position on, would I want it now?
|
||||
The trader has a choice to make: take the $180 profit—which represents a 138 percent profit on the 1.30 debit—or wait for theta to do its thing. The trader looking for a retracement would likely be inclined to take a profit on the trade. Nobody ever went broke taking a profit. But if the trader thinks the stock will sit tight for the remaining time until expiration, he will be happy with this income-generating position.
|
||||
Although the trade in the last, overly simplistic example did not reap its full at-expiration potential, it was by no means a bad trade. Holding the spread until expiration is not likely to be part of a trader’s plan. Buying the 80 put outright may be a better play if the trader is expecting a fast move. It would have a bigger delta than the spread. Debit and credit spreads can be used as either income generators or as delta plays. When they’re used as delta plays, however, time must be factored in.
|
||||
Bull Put Spread
|
||||
The last of the four vertical spreads is a bull put spread. A bull put spread is a short put with one strike and a long put with a lower strike. Both puts are on the same underlying and in the same expiration cycle. A bull put spread is a credit spread because the more expensive option is being sold, resulting in a net credit when the position is established. Using the same options as in the bear put example:
|
||||
With ExxonMobil at $80.55, the June 80 puts are sold for 1.75 and the June 75 puts are bought at 0.45. The trade is done for a credit of 1.30.
|
||||
Exhibit 9.10
|
||||
shows the payout of this spread if it is held until expiration.
|
||||
EXHIBIT 9.10
|
||||
ExxonMobil bull put spread.
|
||||
The sale of this spread generates a 1.30 net credit, which is represented by the maximum profit to the right of the 80 strike. With ExxonMobil above $80 per share at expiration, both options expire OTM and the premium is all profit. Between the two strike prices, the 80 put expires in the money. If the ITM put is still held at expiration, it will be assigned. Upon assignment, the put becomes long stock, profiting with each tick higher up to $80, or losing with each tick lower to $75. If the 80 put is assigned, the effective price of the long stock will be $78.70. The assignment will “hit your sheets” as a buy at $80, but the 1.30 credit lowers the effective net cost to $78.70.
|
||||
If the stock is below $75 at option expiration, both puts will be ITM. This is the worst case scenario, because the higher-struck put was sold. At expiration, the 80 puts would be assigned, the 75 puts exercised. That’s a negative scalp of $5 on the resulting stock. The initial credit lessens the pain by 1.30. The maximum possible loss with ExxonMobil below both strikes at expiration is $3.70 per spread.
|
||||
The spread in this example is the flip side of the bear put spread of the previous example. Instead of buying the spread, as with the bear put, the spread in this case is sold.
|
||||
Exhibit 9.11
|
||||
shows the analytics for the bull put spread.
|
||||
EXHIBIT 9.11
|
||||
Greeks for ExxonMobil 75–80 bull put spread.
|
||||
Instead of having a short delta, as with the bear spread, the bull spread is long delta. There is negative theta with positive gamma and vega as XOM approaches the long strike—the 75s, in this case. There is also positive theta with negative gamma and vega around the short strike—the 80s.
|
||||
Exhibit 9.11
|
||||
shows the characteristics that define the vertical spread. If one didn’t know which particular options were being traded here, this could almost be a table of greeks for either a 75–80 bull put spread or a 75–80 bull call spread.
|
||||
Like the other three verticals, this spread can be a delta play or a theta play. A bullish trader may sell the spread if both puts are in-the-money. Imagine that XOM is trading at around $75. The spread will have a positive 0.364 delta, positive gamma, and negative theta. The spread as a whole is a decaying asset. It needs the underlying to rally to combat time decay.
|
||||
A bullish trader may also sell this spread if XOM is between the two strikes. In this case, with XOM at, say, $77, the delta is +0.388, and all other greeks are negligible. At this particular price point in the underlying, the trader has almost pure leveraged delta exposure. But this trade would be positioned for only a small move, not much above $80. A speculator wanting to trade direction for a small move while eliminating theta and vega risks achieves her objectives very well with a vertical spread.
|
||||
A bullish-to-neutral trader would be inclined to sell this spread if ExxonMobil were around $80 or higher. Day by day, the 1.30 premium would start to come in. With 40 days until expiration, theta would be small, only 0.004. But if the stock remained at $80, this ATM put would begin decaying faster and faster. The objective of trading this spread for a neutral trader is selling future realized volatility—selling gamma to earn theta. A trader can also trade a vertical spread to profit from IV.
|
||||
Verticals and Volatility
|
||||
The IV component of a vertical spread, although small compared with that of an outright call or put, is still important—especially for large traders with low margin and low commissions who can capitalize on small price changes efficiently. Whether it’s a call spread or a put spread, a credit spread or a debit spread, if the underlying is at the short option’s strike, the spread will have a net negative vega. If the underlying is at the long option’s strike, the spread will have positive vega. Because of this characteristic, there are three possible volatility plays with vertical spreads: speculating on IV changes when the underlying remains constant, profiting from IV changes resulting from movement of the underlying, and special volatility situations.
|
||||
Vertical spreads offer a limited-risk way to speculate on volatility changes when the underlying remains fairly constant. But when the intent of a vertical spread is to benefit from vega, one must always consider the delta—it’s the bigger risk. Chapter 13 discusses ways to manage this risk by hedging with stock, a strategy called delta-neutral trading.
|
||||
Non-delta-neutral traders may speculate on vol with vertical spreads by assuming some delta risk. Traders whose forecast is vega bearish will sell the option with the strike closest to where the underlying is trading—that is, the ATM option—and buy an OTM strike. Traders would lean with their directional bias by choosing either a call spread or a put spread. As risk managers, the traders balance the volatility stance being taken against the additional risk of delta. Again, in this scenario, delta can hurt much more than help.
|
||||
In the ExxonMobil bull put spread example, the trader would sell the 80-strike put if ExxonMobil were around $80 a share. In this case, if the stock didn’t move as time passed, theta would benefit from historical volatility being’s low—that is, from little stock movement. At first, the benefit would be only 0.004 per day, speeding up as expiration nears. And if implied volatility decreased, the trader would profit 0.04 for every 1 percent decline in IV. Small directional moves upward help a little. But in the long run, those profits are leveled off by the fact that theta gets smaller as the stock moves higher above $80—more profit on direction, less on time.
|
||||
For the delta player, bull call spreads and bull put spreads have a potential added benefit that stems from the fact that IV tends to decrease as stocks rise and increase when stocks fall. This offers additional opportunity to the bull spread player. With the bull call spread or the bull put spread, the trader gains on positive delta with a rally. Once the underlying comes close to the short option’s strike, vega is negative. If IV declines, as might be anticipated, there is a further benefit of vega profits on top of delta profits. If the underlying declines, the trader loses on delta. But the pain can potentially be slightly lessened by vega profits. Vega will get positive as the underlying approaches the long strike, which will benefit from the firming of IV that often occurs when the stock drops. But this dual benefit is paid for in the volatility skew. In most stocks or indexes, the lower strikes—the ones being bought in a bull spread—have higher IVs than the higher strikes, which are being sold.
|
||||
Then there are special market situations in which vertical spreads that benefit from volatility changes can be traded. Traders can trade vertical spreads to strategically position themselves for an expected volatility change. One example of such a situation is when a stock is rumored to be a takeover target. A natural instinct is to consider buying calls as an inexpensive speculation on a jump in price if the takeover is announced. Unfortunately, the IV of the call is often already bid up by others with the same idea who were quicker on the draw. Buying a call spread consisting of a long ITM call and a short OTM call can eliminate immediate vega risk and still provide wanted directional exposure.
|
||||
Certainly, with this type of trade, the trader risks being wrong in terms of direction, time, and volatility. If and when a takeover bid is announced, it will likely be for a specific price. In this event, the stock price is unlikely to rise above the announced takeover price until either the deal is consummated or a second suitor steps in and offers a higher price to buy the company. If the takeover is a “cash deal,” meaning the acquiring company is tendering cash to buy the shares, the stock will usually sit in a very tight range below the takeover price for a long time. In this event, implied volatility will often drop to very low levels. Being short an ATM call when the stock rallies will let the trader profit from collapsing IV through negative vega.
|
||||
Say XYZ stock, trading at $52 a share, is a rumored takeover target at $60. When the rumors are first announced, the stock will likely rise, to say $55, with IV rising as well. Buying the 50–60 call spread will give a trader a positive delta and a negligible vega. If the rumors are realized and a cash takeover deal is announced at $60, the trade gains on delta, and the spread will now have negative vega. The negative vega at the 60 strike gains on implied volatility declining, and the stock will sit close to $60, producing the benefits of positive theta. Win, win, win.
|
||||
The Interrelations of Credit Spreads and Debit Spreads
|
||||
Many traders I know specialize in certain niches. Sometimes this is because they find something they know well and are really good at. Sometimes it’s because they have become comfortable and don’t have the desire to try anything new. I’ve seen this strategy specialization sometimes with traders trading credit spreads and debit spreads. I’ve had serial credit spread traders tell me credit spreads are the best trades in the world, much better than debit spreads. Habitual debit spread traders have likewise said their chosen spread is the best. But credit spreads and debit spreads are not so different. In fact, one could argue that they are really the same thing.
|
||||
Conventionally, credit-spread traders have the goal of generating income. The short option is usually ATM or OTM. The long option is more OTM. The traders profit from nonmovement via time decay. Debit-spread traders conventionally are delta-bet traders. They buy the ATM or just out-of-the-money option and look for movement away from or through the long strike to the short strike. The common themes between the two are that the underlying needs to end up around the short strike price and that time has to pass to get the most out of either spread.
|
||||
With either spread, movement in the underlying may be required, depending on the relationship of the underlying price to the strike prices of the options. And certainly, with a credit spread or debit spread, if the underlying is at the short strike, that option will have the most premium. For the trade to reach the maximum profit, it will need to decay.
|
||||
For many retail traders, debit spreads and credit spreads begin to look even more similar when margin is considered. Margin requirements can vary from firm to firm, but verticals in retail accounts at option-friendly brokerage firms are usually margined in such a way that the maximum loss is required to be deposited to hold the position (this assumes Regulation T margining). For all intents and purposes, this can turn the trader’s cash position from a credit into a debit. From a cash perspective, all vertical spreads are spreads that require a debit under these margin requirements. Professional traders and retail traders who are subject to portfolio margining are subject to more liberal margin rules.
|
||||
Although margin is an important concern, what we really care about as traders is risk versus reward. A credit call spread and a debit put spread on the same underlying, with the same expiration month, sharing the same strike prices will also share the same theoretical risk profile. This is because call and put prices are bound together by put-call parity.
|
||||
Building a Box
|
||||
Two traders, Sam and Isabel, share a joint account. They have each been studying Johnson & Johnson (JNJ), which is trading at around $63.35 per share. Sam and Isabel, however, cannot agree on direction. Sam thinks Johnson & Johnson will rise over the next five weeks, and Isabel believes it will decline during that period.
|
||||
Sam decides to buy the January 62.50 −65 call spread (January has 38 days until expiration in this example). Sam can buy this spread for 1.28. His maximum risk is 1.28. This loss occurs if Johnson & Johnson is below $62.50 at expiration, leaving both calls OTM. His maximum gain is 1.22, realized if Johnson & Johnson is above $65 (65–62.50–1.28). With Johnson & Johnson at $63.35, Sam’s delta is long 0.29 and his other greeks are about flat.
|
||||
Isabel decides to buy the January 62.50–65 put spread for a debit of 1.22. Isabel’s biggest potential loss is 1.22, incurred if Johnson & Johnson is above $65 a share at expiration, leaving both puts OTM. Her maximum possible profit is 1.28, realized if the stock is below $62.50 at option expiration. With Johnson & Johnson at $63.35, Isabel has a delta that is short around 0.27 and is nearly flat gamma, theta, and vega.
|
||||
Collectively, if both Sam and Isabel hold their trades until expiration, it’s a zero-sum game. With Johnson & Johnson below $62.50, Sam loses his investment of 1.28, but Isabel profits. She cancels out Sam’s loss by making 1.28. Above $65, Sam makes 1.22 while Isabel loses the same amount, canceling out Sam’s gains. Between the two strikes, Sam has gains on his 62.50 call and Isabel has gains on her 65 put. The gains on the two options will total 2.50, the combined total spent on the spreads—another draw.
|
||||
EXHIBIT 9.12
|
||||
Sam’s long call spread in Johnson & Johnson.
|
||||
62.50–65 Call Spread
|
||||
Delta
|
||||
+0.290
|
||||
Gamma
|
||||
+0.001
|
||||
Theta
|
||||
−0.004
|
||||
Vega
|
||||
+0.006
|
||||
EXHIBIT 9.13
|
||||
Isabel’s long put spread in Johnson & Johnson.
|
||||
62.50–65 Put Spread
|
||||
Delta
|
||||
−0.273
|
||||
Gamma
|
||||
−0.001
|
||||
Theta
|
||||
+0.005
|
||||
Vega
|
||||
−0.006
|
||||
These two spreads were bought for a combined total of 2.50. The collective position, composed of the four legs of these two spreads, forms a new strategy altogether.
|
||||
The two traders together have created a box. This box, which is empty of both profit and loss, is represented by greeks that almost entirely offset each other. Sam’s positive delta of 0.29 is mostly offset by Isabel’s −0.273 delta. Gamma, theta, and vega will mostly offset each other, too.
|
||||
Chapter 6 described a box as long synthetic stock combined with short synthetic stock having a different strike price but the same expiration month. It can also be defined, however, as two vertical spreads: a bull (bear) call spread plus a bear (bull) put spread with the same strike prices and expiration month.
|
||||
The value of a box equals the present value of the distance between the two strike prices (American-option models will also account for early exercise potential in the box’s value). This 2.50 box, with 38 days until expiration at a 1 percent interest rate, has less than a penny of interest affecting its value. Boxes with more time until expiration will have a higher interest rate component. If there was one year until expiration, the combined value of the two verticals would equal 2.475. This is simply the distance between the strikes minus interest (2.50–[2.50 × 0.01]).
|
||||
Credit spreads are often made up of OTM options. Traders betting against a stock rising through a certain price tend to sell OTM call spreads. For a stock at $50 per share, they might sell the 55 calls and buy the 60 calls. But because of the synthetic relationship that verticals have with one another, the traders could buy an ITM put spread for the same exposure, after accounting for interest. The traders could buy the 60 puts and sell the 55 puts. An ITM call (put) spread is synthetically equal to an OTM put (call) spread.
|
||||
Verticals and Beyond
|
||||
Traders who want to take full advantage of all that options have to offer can do so strategically by trading spreads. Vertical spreads truncate directional risk compared with strategies like the covered call or single-legged option trades. They also reduce option-specific risk, as indicated by their lower gamma, theta, and vega. But lowering risk both in absolute terms and in the greeks has a trade-off compared with buying options: limited profit potential. This trade-off can be beneficial, depending on the trader’s forecast. Debit spreads and credit spreads can be traded interchangeably to achieve the same goals. When a long (short) call spread is combined with a long (short) put spread, the product is a box. Chapter 10 describes other ways vertical spreads can be combined to form positions that achieve different trading objectives.
|
||||
Note
|
||||
1
|
||||
. Note that it is customary when discussing the purchase or sale of spreads to state the lower strike first, regardless of which is being bought or sold. In this case, the trader is buying the 75–80 put spread.
|
||||
Reference in New Issue
Block a user