39 lines
3.0 KiB
Plaintext
39 lines
3.0 KiB
Plaintext
Chapter 7: Bull Spreads 177
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time to maturity than the short call has. Such a position is known as a diagonal bull
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spread and is discussed in a later chapter.
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Experienced traders often tum to bull spreads when options are expensive. The
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sale of the option at the higher strike partially mitigates the cost of buying an expen
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sive option at the lower strike. However, one should not always use the bull spread
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approach just because the options have a lot of time value premium, for he would be
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giving up a lot of upside profit potential in order to have a hedged position.
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With most types of spreads, it is necessary for some time to pass for the spread
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to become significantly profitable, even if the underlying stock moves in favor of the
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spreader. For this reason, bull spreads are not for traders unless the options involved
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are very short-term in nature. If a speculator is bullishly oriented for a short-term
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upward move in an underlying stock, it is generally better for him to buy a call out
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right than to establish a bull spread. Since the spread differential changes mainly as
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a function of time, small movements in price by the underlying stock will not cause
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much of a short-term change in the price of the spread. However, the bull spread has
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a distinct advantage over the purchase of a call if the underlying stock advances mod
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erately by expiration.
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In the previous example, a bull spread was established by buying the XYZ
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October 30 call for 3 points and simultaneously selling the October 35 call for 1 point.
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This spread can be compared to the outright purchase of the XYZ October 30 alone.
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There is a short-term advantage in using the outright purchase.
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Example: The underlying stock jumps from 32 to 35 in one day's time. The October
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30 would be selling for approximately 5½ points if that happened, and the outright
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purchaser would be ahead by 2½ points, less one option commission. The long side
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of the bull spread would do as well, of course, since it utilizes the same option, but
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the short side, the October 35, would probably be selling for about 2½ points. Thus,
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the bull spread would be worth 3 points in total (5½ points on the long side, less 2½
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points loss on the short side). This represents a 1-point profit to the spreader, less two
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option commissions, since the spread was initially established at a debit of 2 points.
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Clearly, then, for the shortest time period one day - the outright purchase outper
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forms the bull spread on a quick rise.
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For a slightly longer time period, such as 30 days, the outright purchase still has
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the advantage if the underlying stock moves up quickly. Even if the stock should
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advance above 35 in 30 days, the bull spread will still have time premium in it and
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thus will not yet have reached its maximum spread potential of 5 points. Recall that
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the maximum potential of a bull spread is always equal to the difference between the
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striking prices. Clearly, the outright purchaser will do very well if the underlying
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stock should advance that far in 30 days' time. When risk is considered, however, it |