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