40 lines
3.0 KiB
Plaintext
40 lines
3.0 KiB
Plaintext
Chapter 7: Bull Spreads
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FOLLOW-UP ACTION
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179
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Since the strategy has both limited profit and limited risk, it is not mandatory for the
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spreader to take any follow-up action prior to expiration. If the underlying stock
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advances substantially, the spreader should watch the time value premium in the
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short call closely in order to close the spread if it appears that there is a possibility of
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assignment. This possibility would increase substantially if the time value premium
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disappeared from the short call. If the stock falls, the trader may want to close the
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spread in order to limit his losses even further.
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When the spread is closed, the order should also be entered as a spread trans
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action. If the underlying stock has moved up in price, the order to liquidate would
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be a credit spread involving two closing transactions. The maximum credit that can
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be recovered from a bull spread is an amount equal to the difference between the
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striking prices. In the previous example, if XYZ were above 35 at expiration, one
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might enter an order to liquidate the spread as follows: Buy the October 35 (it is
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common practice to specify the buy side of a spread first when placing an order);
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sell the October 30 at a 5-point credit. In reality, because of the difference between
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bids and offers, it is quite difficult to obtain the entire 5-point credit even if expira
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tion is quite near. Generally, one might ask for a 4¼ or 47/s credit. It is possible to
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close the spread via exercise, although this method is normally advisable only for
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traders who pay little or no commissions. If the short side of a spread is assigned,
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the spreader may satisfy the assignment notice by exercising the long side of his
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spread. There is no margin required to do so, but there are stock commissions
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involved. Since these stock commissions to a public customer would be substantial
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ly larger than the option commissions involved in closing the spread by liquidating
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the options, it is recommended that the public customer attempt to liquidate rather
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than exercise.
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A minor point should be made here. Since the amount of commissions paid to
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liquidate the spread would be larger if higher call prices are involved, the actual net
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maximum profit point for a bull spread is for the stock to be exactly at the higher
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striking price at expiration. If the stock exceeds the higher striking price by a great
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deal, the gross profit will be the same (it was demonstrated earlier that this gross
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profit is the same anywhere above the higher strike at expiration), but the net profit
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will be slightly smaller, since the investor will pay more in commissions to liquidate
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the spread.
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Some spreaders prefer to buy back the short call if the underlying stock drops
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in price, in order to lock in the profit on the short side. They will then hold the long
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call in hopes of a rise in price by the underlying stock, in order to make the long side
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of the spread profitable as well. This amounts to "legging" out of the spread, although |