28 lines
1.9 KiB
Plaintext
28 lines
1.9 KiB
Plaintext
The delta of this trade remains negative throughout the stock’s descent to
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$75. Assuming the $5 drop occurs in one day, a delta averaging around
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−0.36 means about a 1.80 profit, or $180 per spread, for the $5 move (0.36
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times $5 times 100). This is still a far cry from the spread’s $3.70 potential
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profit. Although the stock is at $75, the maximum profit potential has yet to
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be reached, and it won’t be until expiration. How does the rest of the profit
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materialize? Time decay.
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The price the trader wants the stock to reach is $75, but the assumption
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here is that the move happens very fast. The trade went from being a long-
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volatility play—long gamma and vega—to a short-vol play: short gamma
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and vega. The trader wanted movement when the stock was at $80 and
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wants no movement when the stock is at $75. When the trade changes
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characteristics by moving from one strike to another, the trader has to
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reconsider the stock’s outlook. The question is: if I didn’t have this position
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on, would I want it now?
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The trader has a choice to make: take the $180 profit—which represents a
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138 percent profit on the 1.30 debit—or wait for theta to do its thing. The
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trader looking for a retracement would likely be inclined to take a profit on
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the trade. Nobody ever went broke taking a profit. But if the trader thinks
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the stock will sit tight for the remaining time until expiration, he will be
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happy with this income-generating position.
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Although the trade in the last, overly simplistic example did not reap its
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full at-expiration potential, it was by no means a bad trade. Holding the
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spread until expiration is not likely to be part of a trader’s plan. Buying the
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80 put outright may be a better play if the trader is expecting a fast move. It
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would have a bigger delta than the spread. Debit and credit spreads can be
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used as either income generators or as delta plays. When they’re used as
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delta plays, however, time must be factored in. |