37 lines
2.9 KiB
Plaintext
37 lines
2.9 KiB
Plaintext
Chapter 12: Combining Calendar and Ratio Spreads 225
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time (they would be at parity), there would be a debit of½ point to close the ratio
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spread. The two April 50 calls would be bought for 6 points and the July 50 call sold
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for 5½ - a ½ debit. The entire spread transaction would thus have broken even, less
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commissions, at 53 at April expiration, since the spread was put on for a ½ credit and
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was taken off for a ½ debit. The risk to the upside depends clearly, then, on how
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quickly the stock rallies above 50 before April expiration.
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CHOOSING THE SPREAD
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Some of the same criteria used in setting up a bullish calendar spread apply here as
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well. Select a stock that is volatile enough to move above the striking price in the
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allotted time - after the near-term expires, but before the long call expires. Do not
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use calls that are so far out-of-the-money that it would be virtually impossible for the
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stock to reach the striking price. Always set up the spread for a credit, commissions
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included. This will assure that a profit will be made even if the stock goes nowhere.
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However, if the credit has to be generated by using an extremely large ratio - greater
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than 3 short calls to every long one - one should probably reject that choice, since
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the potential losses in an immediate rally would be large.
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The upside break-even point prior to April expiration should be determined
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using a pricing model. Such a model, or the output from one, can generally be
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obtained from a data service or from some brokerage firms. It is useful to the strate
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gist to know exactly how much room he has to the upside if the stock begins to rally.
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This will allow him to take defensive action in the form of closing out the spread
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before his break-even point is reached. Since a pricing model can estimate a call
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price for any length of time, the strategist can compute his break-even points at
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April expiration, 1 month before April expiration, 6 weeks before, and so on. When
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the long option in a spread expires at a different time from the short option, the
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break-even point is dynamic. That is, it changes with time. Table 12-1 shows how
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this information might be accumulated for the example spread used above. Since
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this example spread was established for a ½-point credit with the stock at 45, the
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break-even points would be at stock prices where the spread could be removed for
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a ½-point debit. Suppose the spread was initiated with 95 days remaining until April
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expiration. In each line of the table, the cost for buying 2 April 50's is ½ point more
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than the price of the July 50. That is, there would be a ½-point debit involved in
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closing the spread at those prices. Notice that the break-even price increases as time
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passes. Initially, the spread would show a loss if the stock moved up at all. This is to
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be expected, since an immediate move would not allow for any erosion in the time
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value premium of the near-term calls. As more and more time passes, time weighs |