37 lines
2.6 KiB
Plaintext
37 lines
2.6 KiB
Plaintext
Accepting Exposure • 225
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Tactically, once an investor has decided to accept exposure to a stock’s
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upside potential using a call spread, he or she has a relatively limited choice
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of investments. Let’s assume that we sell the ATM strike; in the IBM ex-
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ample shown earlier, there is a choice of nine strike prices at which we
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can cover. The highest dollar amount of premium we can receive—what I
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will call the maximum return—is received by covering at the most distant
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strike. Every strike between the ATM and the most distant strike will at
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most generate some percentage of this maximum return.
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Now let’s look at the risk side. Let’s say that we sell the $195-strike call
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and cover using the $210-strike call. Now assume that some bit of good
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news about IBM comes out, and the stock suddenly moves to exactly $210.
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If the option expires when IBM is trading at $210, we will have lost the
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entire amount of margin we posted to support this investment—$15 in all.
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This $15 loss will be offset by the amount of premium we received from
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selling the call spread—$5.47 in the IBM example—generating a net loss of
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$9.53 (= $5.47 − $15). Compare this with the loss that we would suffer if we
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had covered using the most distant call strike. In this case, we would have
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received $6.96 in premium, so if the option expires when IBM is trading at
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the same $210 level as earlier, our net loss would be $8.04 (= $6.96 − $15).
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Because our maximum return is generated with the widest spread, it fol-
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lows that our minimum loss for the stock going to any intermediate strike
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price also will be generated with the widest spread.
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At the same time, if we always select the widest spread, we face an
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entirely different problem. That is, the widest spread exposes us to the great-
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est potential loss. If the stock goes only to $210, it is true that the widest
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spread will generate a smaller loss than the $195–$210 spread. However, in
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the extreme, if the stock moves up strongly to $240, we would lose the $45
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gross amount supporting the margin account and a net amount of $38.04
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(= $45 – $6.96). Contrast this with a net loss of $9.53 for the $195–$210
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spread. Put simply, if the stock moves up only a bit, we will do better with
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the wider spread; if it moves up a lot, it is better to choose a narrower
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spread.
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In short, when thinking about call spreads, we must balance our
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amount of total exposure against the exposure we would have for an inter-
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mediate outcome against the total amount of premium we are receiving. If
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we are too protective and initiate the smallest spread possible, our chance |