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Nov
30
Vertical Spread Examples
Let’s go back to the Google quotes we used in the last chapter, which have been reproduced as Table 9-5 below:
Table 9-5
Assume you are bullish on Google and wish to buy the $250 call but find that it is trading for $80.40 and decide that is too much to spend on the option. Rather than pass up the opportunity, you decide to use a vertical call spread to reduce the cost of the $250 call. This is the “cheap” version of the vertical call spread; you are selling another option to reduce the cost of the long position. If you buy the $250 call and sell the $260 call, then you are long the $250/$260 vertical call spread.
Depending on your broker’s trading platform, you would enter the order in one of two ways:
1) Buy the Google Jan. $250/$260 vertical call spread at market (or net debit limit)
2) Buy the Google Jan. $250 call and simultaneously sell the Google Jan. $260 call at market (or net debit limit)
If you place the order as a “market” order then you can currently buy the $250 call for the $80.40 asking price and simultaneously sell the $260 call for the $73.20 bid, which means a net cost to you (net debit) of $80.40 - $73.20 = $7.20. In most cases, the market order should fill at this $7.20 price. In some cases, you will pay slightly less since you are sending two orders to the exchange and may get a little better pricing. Of course, because it is a market order it is possible to be filled for a higher price than this as well. (Market orders guarantee the execution but not the price.)
On the other hand, you could decide to use a limit order and request to “Buy the $250/$260 vertical call spread at a net debit of $7.00,” for example. This order will only execute if it can be filled for $7.00 or less. The risk is that it may not fill. (Limit orders guarantee the price but not the execution.)
Once the order is filled, you are long the $250 call and short the $260 call. You have the right to buy shares for $250 and the obligation to sell them for $260, which means the most you could make is $10 on the spread. But because you paid $2.80 for the spread, the maximum profit is $10 - $7.20 = $2.80. We also know the breakeven point is the net debit added to the $250 strike, or $250 + 7.20 = $257.20. The profit and loss diagram in Figure 9-6 confirms the maximum gain, loss, and breakeven points we calculated based on our knowledge of option pricing principles:
Figure 9-6: Long $250/$260 Vertical Call Spread
Now let’s check the profit and loss profile for the corresponding put spread. Rather than buy the $250/$260 vertical call spread we know you could accomplish the same thing by selling the $250/$260 vertical put spread. Selling this spread means you will be selling the more valuable option, which is the $260 strike and that means you must buy the $250 strike.
According to the quotes, you can sell the $260 put for $25.80. However, this subjects you to unlimited downside loss, which is a frightening thought. To hedge this risk, you decide to use some of that premium to buy a lower strike put. This is the “chicken” version of the vertical spread. Your real goal is to sell the controlling $260 put but the purchase of the $250 put is done as a hedge. If you sell the $260 put and buy the $250 put, then you are short the $250/$260 vertical put spread. The order to your broker would be placed in one of the following two ways:
1) Sell the Google January $250/$260 vertical put spread at market (or net credit limit)
2) Sell to open, the Google Jan. $260 put and simultaneously buy to open the Google Jan. $250 put at market (or net credit limit)
If you place the order as a “market” order then you can currently sell the $260 put for the $25.80 bid and simultaneously buy the $250 put for the $22.80 asking price, which means the net credit to you is $25.80 - $22.80 = $3.00. As with any market order, this is not guaranteed to fill for this exact price but it should be very close. If you want to ensure that you do not receive less than $3.00 you would need to use a limit order with a “net credit of $3.00.”
Your broker will require a margin deposit for any credit spread equal to the amount of the maximum loss. In this example, if you sell one spread for $300, your broker will withhold $700 as a margin requirement (the $10 difference in strikes less the $3 credit). Again, this clearly shows that credit spreads are not better for the sole reason that it is better to receive money rather than spend it as so many traders adamantly believe. Credit spreads require a margin deposit exactly equal to the amount that debit spreads must pay to buy the spread. Whether it is called a debit or a margin requirement, both traders pay the same thing.
By selling the $260 put you have the obligation to buy shares for $260. Purchasing the $250 put gives you have the right to sell shares for $250. Therefore, it is possible you could end up buying for $260 and selling for $250, which creates a $10 loss on the spread; but because you were paid $3 for the spread, your maximum loss is $7.00. Figure 9-7 shows the profit and loss diagram for the short $250/$260 vertical call spread:
Figure 9-7: Short $250/$260 Vertical Put Spread
Notice that the shape of Figure 9-7 is identical to Figure 9-6, which confirms that selling the put spread is identical to buying the call spread. However, notice that the max gain for the put spread is $3 and is only $2.80 for the call spread, while the max loss for the put spread is $7.00 but is $7.20 for the call spread. In other words, the short put spread offers a higher reward for less risk. This would be a time to choose the credit spread over the debit spread. The reasons why these slight pricing discrepancies occur are beyond our scope but a simple explanation is that the puts are out-of-the-money while the calls are in-the-money. Most investors fear the downside risk of the stock and are willing to “pay up” for out-of-the-money puts for insurance against their long stock positions. The out-of-the-money $260 puts are bid up a little higher than the corresponding in-the-money $260 call which makes the credit spread a little better in this instance. Remember, this will not always be the case and sometimes the debit spread will be the better choice. (For instance, using Table 9-5, buying the $290/$300 call spread provides a maximum reward of $4.20 while selling the corresponding put spread yields a maximum or $4.10. In this case, it is better to buy the call spread.)
Nov
29
There is a second method (which is probably more logical) for determining whether a vertical spread is bullish or bearish. This can be done as a two-step process. First, find out which option is most valuable and that is the one that controls the position. Second, find out whether that option is being bought or sold. Now just determine whether buying or selling that option by itself is bullish or bearish and you’ll have the correct answer.
For example, using our $50/$55 vertical call spread, we know the $50 call is more valuable since it is a lower strike. Once we have identified the more valuable strike, we then need to find whether that option is being purchased or sold. If the $50 call is bought then you are really buying a call, which is bullish. Therefore, buying the $50 call and selling the $55 call must be a bull spread since the trader is buying the controlling call option. Buying a call is bullish.
On the other hand, if you sell the $50 call and buy the $55 call then it is a bear spread since the trader is selling the controlling $50 call. Selling a call is bearish.
Identifying the controlling option is an easy way to identify long and short vertical spreads once you start trading them. For instance, assume you find a quote for the $50/$55 vertical call spread. If you buy the vertical spread, you will be buying the $50 call and selling the $55 call. Again, buying the spread just means you are buying the more valuable option. On the other hand, if you sell the spread, you will be selling the $50 call and buying the $55 call. Selling the spread means you are selling the more valuable option. Notice that it is the more valuable $50 call that determines whether the spread is being purchased or sold.
Let’s try it for the $50/$55 vertical put spread. The more valuable strike is the $55 strike. If you buy that strike then it is a bear spread since you are buying the controlling put. Buying a put is bearish. On the other hand, if you sell the $55 put then it is a bull spread since you are selling the controlling call. Selling a put is bullish.
While you are learning spreads, start by using the BLSH mnemonic to find if the strategy is bullish or bearish. But as you continue to work with spreads, gradually adopt the method of identifying which is the controlling strike and then identify whether you are buying or selling that strike and you will always be certain of your answer.
Rationale for Spreads
With this information, it is now easier to understand the rationale for vertical spreads. If you buy a vertical spread, you are buying the more valuable option. The sale of the other option is simply done to reduce the cost of the long option. Buying a vertical spread is a strategy, as we will discover shortly, that allows investors and traders to enter into long option positions they may otherwise consider too expensive. Long vertical spreads solve the expensive option problem.
On the other hand, if you sell a vertical spread, you are selling the more valuable option. Whenever you sell an option, you are accepting an obligation. By selling a call option, you have the obligation to deliver shares for a fixed price and there is no telling how high the price of that stock may be when it comes time to deliver the shares. Selling a put option gives you the obligation to buy shares at a fixed price and there’s no telling how low the price of those shares may be at that time. In other words, selling an option by itself (naked) entails a lot of risk. However, the vertical spread requires that you purchase another option, which acts as a hedge and completely defines the maximum loss. In other words, when you sell a vertical spread, you are really interested in selling the more valuable option. The purchase of the other option is done to reduce the risk of the short option.
Cheap or Chicken
We have shown that the debit trader is really interested in purchasing the more valuable option. By entering the spread, the trader can reduce the premium paid for this long position. For the credit spread trader, the goal is to sell the more valuable strike and receive a premium; however, the trader is now exposed to potentially unlimited losses. By entering a vertical spread, the trader takes some of the premium from the sale of the short option and buys another option to hedge adverse stock price movement.
There is a somewhat humorous, although valuable way of understanding the philosophies between credit and debit spreads. We can say the debit trader is “cheap” since he does not want to pay a lot for the long call position by itself. Selling the less valuable option reduces the price.
The credit spread is considered “chicken” as his goal is to sell the more valuable strike but he is fearful of the unlimited risk. Buying the less valuable option provides a hedge. So remember “cheap” or “chicken” to help identify the underlying philosophies.
Early Assignment
Traders new to vertical spreads are often concerned they may get assigned early on the short position. If so, does it pose a risk? Assume you buy one $50/$55 vertical call spread (buy the $50 call and sell the $55 call) for a net debit of $2. The very most this spread could ever be worth is the $5 difference in strikes, which would leave you with a $3 profit. Now assume that the stock rises above $55 prior to expiration and you are assigned on the short $55 call. If you are assigned on the $55 call, you are required to sell shares for $55 per share. However, if you do not have the shares then your broker will short shares in your account so that the stock can be delivered to the person exercising the $55 call. The end result is that you have a long $50 call plus a short stock position of 100 shares.
When you find out you have been assigned early, you can do one of two things. First, exercise your $50 call and cover the short stock position. This means you will have purchased shares for $50 and sold them for $55 thus locking in the guaranteed $5
maximum gain early, which is a very good thing. This shows that if the stock price is the same or higher the next day there is no risk to you. Simply exercise the long $50 call and collect the $5 maximum gain.
Nov
28
Max Gain, Max Loss, and Break Even with Trading Options
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Max Gain, Max Loss, and Break Even
Figure 9-2 shows that the trader does, in fact, have limited downside risk and limited upside reward as we suspected. The maximum loss, as with any long option position, is the amount paid for the position, which is $2 for this example. What is the maximum gain? If you remember Pricing Principle #6, you should know that the maximum value between any two strikes within the same month is the difference in strikes. Therefore, if you are long the $50 call and short the $55 call then the most that spread could ever be worth is $5. Because you paid $2 for it, the most you could ever make is $3, which is exactly what Figure 9-2 shows.
We can arrive at the same answer by checking our rights and obligations. By purchasing the $50 call and selling the $55 call, the trader has the right to buy stock for $50 and the potential obligation to sell it for $55. If you purchase stock for $50 and sell it for $55 then that is a $5 profit. In order to acquire this right, it cost you a net debit of $2 so the most you could make is $3. If you add the maximum gain and maximum loss together you will always find they equal the difference in strikes. The key point to remember is that if you buy a vertical spread then the most you could ever receive is the difference in strikes (your profit depends on the price paid for the spread). In other words, if you buy an asset, you expect a reward. If you buy a vertical spread, the biggest that reward could ever be is the difference in strikes.
The profit and loss profile for Figure 9-2 shows that the trader makes money if the underlying stock rises, and it is therefore called a bull spread. Specifically, if the stock rises above the $55 strike then the trader makes the full $5 on the spread ($3 profit). The trader can make a smaller profit for expiration stock prices below $55 down to the breakeven point. Where is the breakeven point? The trader is effectively long the $50 call for a cost of $2 and that means the stock must be at $52 at expiration in order for the trader to break even. If the stock is $52, the $50 call is worth the $2 intrinsic value and the $55 call expires worthless, which means the trader breaks even. So the trader makes a profit at expiration for all stock prices above $52 and makes a maximum profit for all stock prices above $55. The trader takes a loss at expiration for all stock prices below $52 and has a maximum loss for all stock prices below $50. The maximum gains, losses, and break-points are fast and easy to calculate if you understand the Pricing Principles discussed in Chapter Two.
Vertical Bull Spread Using Puts
Let’s now take a look at how we can construct the same profit and loss diagram using puts. If you buy the $50 put for $1 and sell the $55 put for $4 then the profit and loss diagram looks like Figure 9-3:
Figure 9-3: Profit and Loss Diagram for Long $50/$55 Vertical Put Spread
Notice that Figures 9-2 and 9-3 are identical. However, the way they arrive at the same shapes is a little different. If you buy a $50 put and sell a $55 put you will receive a credit for the trades since you are selling a higher-strike (more valuable) put. Buying the $50 put and selling the $55 put is therefore a short $50/$55 vertical bull spread.
By selling the $55 put, you have the potential obligation to buy shares for $55.
By purchasing the $50 put, you are assured that you can always sell shares for $50. If you buy shares for $55 and sell them for $50 then you have a $5 loss. However, since you were paid $3 for the spread position the most you could lose is $2. The important point to remember is that if you sell a vertical spread then the most you could ever lose is the difference in strikes (with your profit depending on the price received for the spread). In other words, if you sell an option, you have some type of potential obligation. If you sell a vertical spread, the biggest obligation you will ever face is to owe the difference in strikes.
Many traders make the incorrect assumption that credit spreads must be better than debit spreads based on the premise that it is better to receive money rather than spend it. The truth is that for any given strikes, debit and credit spreads are theoretically identical, which is confirmed by the profit and loss diagrams. In practice though, professional traders will choose one over the other due to slight favorable pricing variations that can occur for a number of reasons. For instance, using the call and put examples above, you may find that one has a maximum loss of $2 and a maximum gain of $3 while the other has a maximum loss of $1.90 and a maximum gain of $3.10, which is slightly better. But a professional trader would never choose the credit spread “just because” it produces a credit. You must always check the maximum gains and losses to determine which is better at that time.
We just showed that we can create a vertical bull spread by using calls or puts. Notice that there is a similarity between the two versions in that both are created by purchasing a lower strike option and selling a higher strike option. This is easy to remember if you look at the first letters of the phrase "Buy Low, Sell High," or BLSH, which resembles the word “bullish.” Any time you buy a lower strike option and sell a higher strike option of the same type (call or put) then you create a vertical bull spread.
Of course, if you do the reverse and buy a high strike and sell a lower strike, then that is a bearish position and you’d need the underlying to fall. Bear spreads work identically to bull spreads but in the opposite direction. It is crucial to understand that buying the vertical call spread is identical to selling the corresponding (same strikes) vertical put spread.
Vertical Bear Spreads
Let’s now take a look at examples of how to create vertical bear spreads, which we found are created by purchasing an option and selling another at a lower strike. Using our previous example, you could create a vertical bear spread by purchasing the $55 call and selling the $50 call for a net credit of $2, which means it is a short position. How do we know this trade can be executed for a net credit of $2? It should make intuitive sense because it is just the opposite side of the trade. In the bull spread example, we assumed the trader bought the $50 call and sold the $55 call for a net debit of $2. Therefore, the trader on the other side must be selling the $50 call and buying the $55 call in exchange for the $2 that the long trader is paying. It is just two traders taking opposite views of the market and trading “packages” of options rather than a single call or put.
The profit and loss diagram for the short $50/$55 vertical call spread looks like Figure 9-4:
Figure 9-4: Profit and Loss Diagram for Short $50/$55 Vertical Call Spread
Figure 9-4 shows that the trader needs the stock price to fall in order to make money on the spread, which is why it is a bear spread. Specifically, the stock needs to fall below $50 at expiration in order to gain the maximum profit. With the stock below $50, both call options expire worthless and the trader keeps the $2 credit. If the stock rises above $50 though, he will be facing an adverse stock price movement. Because of the $2 credit, the trader can afford to have the stock price rise $2 above the $50 strike, or $52, in order to break even at expiration, which is confirmed by Figure 9-4.
Let’s work through the rights versus obligations to further understand what is happening. If you sell a $50 call, you have the obligation to sell shares at $50. If you buy the $55 call, you have the right to buy shares for $55. Therefore, if you buy for $55 and sell for $50 then you have a $5 loss. But because you were paid $2 to put the trade on then the maximum you can lose is $3. As with the bull spreads, notice that the maximum gain ($2) and maximum loss ($3) must add up to the difference in strikes ($5).
We can also accomplish the same profit and loss diagram by using puts, which is done in exactly the same way as the calls – buying one strike and selling lower strike. Using our previous put example, you could create a vertical bear spread by purchasing the $55 put for $4 and selling the $50 put for $1. Because this results in a net debit, it is a long vertical bear spread. If you buy the $55 put and sell the $50 put, the profit and loss diagram will be identical to that of Figure 9-4.
To understand why, let’s check the rights and obligations of the trade. By purchasing the $55 put you have the right to sell stock for $55. Selling the $50 put gives you the potential obligation to buy stock at $50. If you buy for $55 and sell for $50 then you have a $5 gain, but because you paid a net debit of $3 for the spread, the most you can make is $2.
As with the call spread, both versions of the bear spreads should theoretically produce identical maximum gains and losses. Buying the vertical put spread is identical to selling the vertical call spread.
Buying the vertical call spread is identical to selling the corresponding vertical put spread.
Buying the vertical put spread is identical to selling the corresponding vertical call spread.
While the call and put versions of each spread are theoretically identical, small pricing discrepancies will cause one to be a little better than the other and that’s the one the trader should choose. Again, do not choose the call version “just because” it produces a credit. Credits are not necessarily better than debits as the profit and loss diagrams show. It is the interaction between the right to buy and the obligation to sell that makes the strategy work.
We have shown that vertical bull spreads are created by purchasing the lower strike and selling the higher strike, or BLSH, which is bullish. On the flip side, vertical bear spreads are done by purchasing the high strike and selling the low strike. The problem with this mnemonic is that it relates to strike prices and not the option prices. If you buy the low priced option and sell the high priced option, you won’t necessarily get the right answer (you’ll be right for put spreads but not call spreads).
Nov
27
Vertical Spreads
Up to now, we have learned to use long or short options in conservative ways. Chapter Seven showed how to sell a call option against long stock to create a covered call. Chapter Eight showed how to purchase a call or put as a substitute for long stock or short stock positions. Both of these chapters, however, involved the use of a single option.
As you gain experience with options, you will find there are many strategies that involve the use of two or more options at the same time. While these are considered intermediate-to-advanced-level strategies, we want to touch on a very popular one so you can gain an appreciation of the versatility of options. That strategy is called a vertical spread.
There are many “spread” strategies you can use with options. Regardless of the strategy, all spreads have one thing in common: They always involve the purchase of one option and the simultaneous sale of another of the same type (call or put). In other words, if you are using a spread strategy, you will be long and short the same type of option at the same time.
There are various names for these strategies depending on which option you are buying and which you are selling. These names can be confusing for new traders since there are no standardized names, and you will see multiple names for the same strategy. However, there is a standard from which all names for spread strategies are derived. The strategy names came about from the way option quotes used to be printed at the exchanges prior to electronic quotation systems. Traders would create a grid by (usually using chalk boards along the walls of the trading floors) listing the various months across the top and the strikes along the side and then write the quotes in the appropriate boxes as shown in Table 9-1:
Table 9-1
If you buy and sell different strikes within the same month then it is called a vertical spread. For example, using Table 9-1, if you buy the January $50 call for $13.25 and sell the January $55 call for $10.25 as shown by the vertical oval, then it is called a vertical spread since the prices are listed vertically in the grid. A vertical spread is also known as a price spread since it is the prices on the vertical axis that are being spread (bought and sold).
On the other hand, if you buy the March $50 call for $18.10 and sell the February $50 call for $16.25 then it is called a horizontal spread since the prices are listed horizontally in the grid. Horizontal spreads are also called calendar spreads, since it is the calendar months being spread, or time spreads, since the calendar months also measure time. So horizontal spreads, calendar spreads, and time spreads are three different names you will see that all represent the same strategy (calendar spread is probably the most commonly used).
Finally, if you buy and sell different strikes within different months then it is called a diagonal spread. If you buy the March $60 for $9.40 call and sell the February $65 call for $4.90 as shown by the diagonal oval then it is a diagonal spread.
While all of these are fascinating strategies, we are only going to focus on one of them since our goal is to introduce you to strategies where two options are used at the same time. Of these strategies, the simplest is probably the vertical spread so that’s where we will focus the rest of the chapter.
Vertical Spreads
As stated earlier, all spreads are constructed by using all calls or all puts. In other words, if you buy a call you must sell a call. If you buy a put, you must sell a put. Spreads never involve the use of calls and puts at the same time.
The vertical spread is constructed by purchasing one call (or put) within a given month and selling a different strike call (or put) with the same expiration. For example, buying a January $50 call and selling a January $55 call, or buying a March $70 put and selling a March $75 put are vertical spreads. The strike prices can be separated by any amount but, in practice, most traders use sequential strikes. Just understand that spreads are very flexible and you can buy and sell any strikes. Whichever strikes you choose, the options are always bought and sold in a 1:1 ratio which simply means that you are selling one option for every option you buy.
As a matter of notation, if you buy the $50 call and sell the $55 call it is called a $50/$55 vertical spread. Because you purchased the $50 call and sold the $55 call it is a “long” $50/$55 vertical spread. Why is it considered a long position? Because you bought the more valuable option (lower strike call) and that means that money must be spent to buy the spread. Any time you spend money to acquire a position, it is considered a long position. Consequently, long vertical spreads are also called “debit” spreads. If you buy a $70 put and sell the $75 put it would be considered a “short” $70/$75 vertical spread. This is a short position since you sold the more valuable put (higher strike), so you collect money for entering the position. Any time you receive money to enter the position, it is considered “short.” Short vertical spreads are also called “credit” spreads.
Hopefully you’re starting to see why it’s so important to understand the Pricing Principles we discussed in Chapter Two. Investors who try to memorize these strategies (as well as more advanced ones) have a difficult time and are prone to making mistakes. By understanding the Pricing Principles we discussed in Chapter Two, you will always be able to determine with confidence if a particular vertical spread is long or short.
What does the profit and loss profile look like for a vertical spread? You know that long options have limited risk. You also know that selling an option (such as with the covered call) limits potential gains. Therefore, if you combine a long and short option within the same expiration month, you will get a profit and loss profile with limited risk and limited reward.
For instance, if you buy the January $50 call for $3 and sell the January $55 call for $1 then your profit and loss curve looks like Figure 9-2:
Figure 9-2: Profit and Loss Diagram for Long $50/$55 Vertical Call Spread
Notice that this is a “long” $50/$55 vertical call spread since you paid money to acquire it. We would say the trader is long the $50/$55 vertical call spread at a cost, or net debit, of $2. Again, the “net debit” just means it is the net amount spent on the trade. It doesn’t matter if the trader spent $3 for the $50 call and sold the $55 call for $1 or if he paid $10 and sold for $8. The profit and loss diagram looks the same because the “net” amount spent in both cases was $2 and that is all that matters to the trader.
Vertical spreads offer limited risk and limited rewards.
Nov
26
Trading Options - Chapter Eight – Answers
1) You wish to buy shares of AGN stock and would like to buy a call option instead. You believe the stock will rise slowly over the next month. Which strike should you buy?
a) $105
Because you are uncertain about the speed at which the stock’s price will rise, you will want to purchase a call that has a relatively high delta (relatively small time value). Because no delta values are shown, we can find a put that has about 30- or 40-cent time value above the cost of carry. Because there are 43 days until expiration, we can ignore the cost of carry and find a put with roughly 30 to 40 cents in time value. There aren’t any in that range but, for the quotes given, the strike closest to that is the $105 call.
2) Assume you decide to buy THREE contracts of the April $105 calls “at market.” Which of the following is the correct order?
b) Buy to open, three contracts, April $105 calls at market.
You are buying the contract and you are “entering” or “increasing” your position so it is an “opening” transaction.
3) Assume you are filled at the asking price, how much will the trade in Question 2 cost not counting commissions?
d) $2,520
The asking price on the $105 call is $8.40 so three contracts will cost 300 * $8.40 = $2,520 not counting commissions.
4) What is the breakeven point for the $105 call assuming you purchased it for the asking price?
a) $113.40
Because you paid $8.40 for the $105 call, the stock must be at $105 + $8.40 = $113.40 at expiration in order for you to break even on the trade. If the stock is $113.40 at expiration, the $105 call is worth the intrinsic value of $8.40 and you would just break even.
5) What is the breakeven point for the $120 call assuming you purchased it for the asking price?
b) $120.90
The $120 call will break even at $120 + 0.90 = $120.90 at expiration.
6) Why is the breakeven point higher for the $120 when compared to the $105 call?
b) The $120 call is riskier
The $120 call costs only 90 cents which may make it appear less risky. However, once we check the breakeven point we find it is $120 + 0.90 = $120.90 and realize the stock price must move much higher at expiration before you would break even on the trade. The $120 call has a much better chance of expiring worthless so it is riskier than the $105 call.
7) How much time value is in the $105 call?
d) $1.80
With the stock at $111.60, the $105 call has $111.60 - $105 = $6.60 intrinsic value. Because it is trading for $8.40 the additional value of $8.40 - $6.60 = $1.80 must be due to time value.
What is the true risk of the $105 call compared to the stock? a) $1.80
The true risk of buying the $105 call rather than the stock is the $1.80 time value.
9) Why is the risk of the $105 call NOT the full $8.40 value?
a) There is $6.60 of intrinsic value that is also at risk if you owned the stock
Even though the option is trading for $8.40 and could end up worthless, the full $8.40 is not the total risk of the option. This is because if the stock price falls below $105 at expiration then the stock buyer and the $105 call buyer both lose $6.60 worth of intrinsic value. That intrinsic value is a risk that is common to both the option and the stock. The only risk over and above the stock is the $1.80 time premium.
10) You own three $105 calls and wish to sell them “at market.” Which of the following is the correct order?
a) Sell to close, three contracts, April $105 calls at market.
You are “exiting” or “reducing” your position so it is a “closing” transaction.
11) Assume you purchased the $105 call for $8.40 and sold it for the $10.70 bid. What is the return on your investment?
b) 27%
The return is found by taking the ending value and dividing it by the beginning value and subtracting one. In this case, $10.70/$8.40 = 1.27. After subtracting one, we find the return is 0.27, or 27%.
12) What would your return be if you had purchased the stock for $111.60 and sold for $114.49?
a) 2.5%
Buying the stock will always produce a smaller percentage return. In this example, $114.49/$111.60 = 1.025, or 2.5%.
13) If the $105 call expired right now, what would it be worth?
a) $9.49
With the stock at $114.49, the $105 call would be worth the intrinsic value of $114.49 - $105 = $9.49 if it expired this instant.
14) If the $120 call expired right now, what would it be worth?
a) $0
b) $1.50
c) $1.60
d) $1.90
15) If you purchased the $120 call for $0.90 and sold it for $1.50 your return would be 66%. Why is it so much higher than the return on the $105 call?
c) The $120 call is riskier and therefore has higher returns
Remember, as shown in Question 6, the breakeven point is higher so the $120 call has a much better chance of expiring worthless.
16) Assume you wanted to roll up from the $105 call to the $110 call “at market.” Which of the following is the correct order?
c) Sell to close the $105 call and simultaneously buy to open the $110 call
When you are rolling up a call option, you are selling a lower strike call to close and simultaneously buying a higher strike (usually the next higher strike). After the order is filled, you are left holding the higher strike call but you bring in a credit for doing so.
17) Assuming you rolled up from the $105 call to the $110 at the current bid and ask prices, the order would be filled for:
b) A net credit of $3.90
You could sell your long $105 call for the current bid of $10.70 and use that money to buy the $110 call for the $6.80 asking price, which leaves you with a net credit of $10.70 - $6.80 = $3.90. This credit reduces your original cost basis and risk of your original principal.
18) Assume you owned the $115 call and rolled up to the $120 call at the current bid and ask prices. The order would be filled for:
b) A net credit of $1.90
You could sell the long $115 call for $3.50 and buy the $120 call for $1.60 thus receiving a net credit of $3.50 - $1.60 = $1.90.
19) Why is the net in Question 17 larger than that for Question 18?
b) The $105 and $110 strikes are in-the-money so they are more likely to expire with intrinsic value.
Because the $105 and $110 strikes are in-the-money at this time, they are more likely to expire with intrinsic value when compared to the $115 and $120 strikes. Because of this, the market will bid up their prices higher. Remember that the maximum difference for the $105/$110 roll is the $5 difference in their strikes. The very most you could even receive on this roll is therefore $5. The same is true for the $115/$120 roll. However, because the $115/$120 roll is less likely to have intrinsic value, its net difference will be smaller.
20) Assume you originally thought AGN was going to fall and, instead, purchased THREE of the $115 puts from the first set of quotes. You later sold them for the bid price in the second set of quotes. What is your overall gain or loss not counting commissions?
d) $510 loss
You would have purchased the $115 puts for the $5.00 asking price and sold them for the $3.30 bid price for a loss of $1.70 per contract or 300 * 1.70 = $510 for three contracts. Notice, however, that had you shorted the stock you would have sold $11.60 and purchased back for $114.49 for a loss of $2.89 or $867 for 300 shares. The puts reduced your losses for adverse movements due to the implicit call option they contain.
Nov
25
Trading Options - Chapter Eight – Questions
Use the following table of quotes for questions 1 – 9:
1) You wish to buy shares of AGN stock and would like to buy a call option instead. You believe the stock will rise slowly over the next month. Which strike should you buy?
a) $105
b) $110
c) $115
d) $120
2) Assume you decide to buy THREE contracts of the April $105 calls “at market.” Which of the following is the correct order?
a) Sell to close, three contracts, April $105 calls at market
b) Buy to open, three contracts, April $105 calls at market
c) Buy to close, three contracts, April $105 calls at market
d) Buy to open, three contracts, April $105 calls at $8.00 or better
3) Assume you are filled at the asking price, how much will the trade in Question 2 cost not counting commissions?
a) $270
b) $3,360
c) $690
d) $2,520
4) What is the breakeven point for the $105 call assuming you purchased it for the asking price?
a) $113.40
b) $116.40
c) $112.20
d) $105.00
5) What is the breakeven point for the $120 call assuming you purchased it for the asking price?
a) $122.40
b) $120.90
c) $119.10
d) $120.00
6) Why is the breakeven point higher for the $120 when compared to the $105 call?
a) The $120 call is less risky
b) The $120 call is riskier
c) The $120 call is equally risky as the $105
d) The $120 call has less time value so will have a higher break-even point
7) How much time value is in the $105 call?
a) $6.60
b) $8.40
c) $2.20
d) $1.80
What is the true risk of the $105 call compared to the stock? a) $1.80
b) $8.40
c) $6.60
d) $2.20
9) Why is the risk of the $105 call NOT the full $8.40 value?
a) There is $6.60 of intrinsic value that is also at risk if you owned the stock
b) There is $1.80 of intrinsic value that is also at risk if you owned the stock
c) The stock has time value and the option does not
d) The option must expire with intrinsic value
Use the following table of quotes for questions 10 – 20:
10) You own three $105 calls and wish to sell them “at market.” Which of the following is the correct order?
a) Sell to close, three contracts, April $105 calls at market.
b) Sell to open, three contracts, April $105 calls at market.
c) Buy to close, three contracts, April $105 calls at market.
d) Sell to close, three contracts, April $105 calls at $11.50 or better.
11) Assume you purchased the $105 call for $8.40 and sold it for the $10.70 bid. What is the return on your investment?
a) 78%
b) 27%
c) 44%
d) 21%
12) What would your return be if you had purchased the stock for $111.60 and sold for $114.49?
a) 2.5%
b) 4.2%
c) 6.5%
d) 7.8%
13) If the $105 call expired right now, what would it be worth?
a) $9.49
b) $10.70
c) $10.90
d) $7.70
14) If the $120 call expired right now, what would it be worth?
a) $0
b) $1.50
c) $1.60
d) $1.90
15) If you purchased the $120 call for $0.90 and sold it for $1.50 your return would be 66%. Why is it so much higher than the return on the $105 call?
a) The $105 call is riskier because it costs more money and will therefore have lower returns
b) The $120 call is less risky and therefore has higher returns
c) The $120 call is riskier and therefore has higher returns
d) The $105 call and $120 call are equally risky. The increased return on the $120 call is due to volatility
16) Assume you wanted to roll up from the $105 call to the $110 call “at market.” Which of the following is the correct order?
a) Sell to open the $105 call and simultaneously buy to open the $110 call
b) Sell to close the $110 call and simultaneously buy to open the $105 call
c) Sell to close the $105 call and simultaneously buy to open the $110 call
d) Buy to close $105 call and simultaneously buy to open the $110 call
17) Assuming you rolled up from the $105 call to the $110 at the current bid and ask prices, the order would be filled for:
a) A net debit of $3.90
b) A net credit of $3.90
c) A net debit of $4.30
d) A net credit of $4.30
18) Assume you owned the $115 call and rolled up to the $120 call at the current bid and ask prices. The order would be filled for:
a) A net debit of $1.90
b) A net credit of $1.90
c) A net debit of $2.20
d) A net credit of $2.20
19) Why is the net in Question 17 larger than that for Question 18?
a) The $105 and $110 strikes are out-of-the-money so they are more likely to expire with intrinsic value
b) The $105 and $110 strikes are in-the-money so they are more likely to expire with intrinsic value
c) The $105 and $110 strikes are out-of-the-money so they are more likely to expire worthless
d) The $105 and $110 strikes are in-the-money so they are more likely to expire worthless
20) Assume you originally thought AGN was going to fall and, instead, purchased THREE of the $115 puts from the first set of quotes. You later sold them for the bid price in the second set of quotes. What is your overall gain or loss not counting commissions?
a) $360 gain
b) $360 loss
c) $510 gain
d) $510 loss
Nov
24
Trading Rolling Options
Filed Under Beginner Options Trading | Leave a Comment
There are many times when you can execute roll-ups. You may decide to always roll up to the at-the-money option thus bringing in more cash (a bigger net credit) at the expense of needing bigger moves in the stock before rolling up again. It all depends on your goals and risk tolerances. Some investors will roll up sooner while some take a little more risk and roll up less frequently in the search for higher profits due to fewer bid-ask spreads and commissions.
For example, at the time of this writing, Google had released very positive earnings and was starting to move aggressively upward. In light of this news, you might decide to hold the option for longer periods of time to reduce the commissions you must pay to execute each roll-up. Let’s assume you decide to hang on for a while before rolling up again. Table 8-8 shows that one month later Google was trading for more than $380!
Table 8-8
If you rolled up at this time, you’d want to roll up to a strike that is closer to the current price of the stock rather than rolling to the $320 strike, which is the next strike higher than the $310 strike we’re currently holding. The reason is that the $320 strike is very deep in-the-money, and we’d like to hold an option that is only one strike in-the-money or possibly at-the-money, which allows us to sweep more money out of the position. Let’s assume we decide to roll up to the at-the-money strike, which is the $380 strike. All you have to do is place the following order:
Sell to close, one contract, Google Jan. ’07 $310 call (OQDAB) and simultaneously
Buy to open, one contract, Google Jan. ’07 $380 call (OQDAU) at market (limit)
The net credit produced would be $37.80 as follows:
Sell $310 call = + $109.20
Buy $380 call = -$71.40
Net credit = $37.80
Prior to this trade, our cost basis was $48.60. After receiving the $37.80 credit, the cost basis is reduced to $11. Notice that we could choose to roll up to an out-of-the-money strike such as the $390 call. If we do, we’ll end up with a bigger credit from the roll since we are spending less money to buy the $390 call, which provides a bigger credit. The tradeoff is that the stock must now move higher before we’re able to execute the next roll-up.
Regardless of which choice you make, you still control 100 shares of Google but have taken a tremendous amount of cash out of the position. It is doubtful that the “conservative” stock owner would have held out for this much profit because there’s too much to lose as the stock price climbs to seemingly inexplicable levels. However, with options, we can sweep money out of the position and still control 100 shares by using options. As we’ve tried to point out, options can be used in conservative ways.
This example highlights the importance of rolling up at more frequent intervals. When we started this exercise, we purchased the Google $290 call for $58. After the last roll-up, we figure that the cost basis is now $11 which means we have taken $58 - $11 = $47 out of the position through several roll-ups. Using Table 8-8, notice that if we had never rolled up until now, we could have sold the $290 call for $122.70 and purchased the $380 call for $71.40, thus bringing in one giant credit of $51.30, which is not too far from the $47 we’ve pulled out so far. Why the difference? The reason is the bid-ask spread. Every time we buy or sell, we must pay the asking price and receive the bid price. These actions create a small leak in the total credits we receive. Commissions will obviously reduce the total credits even further. In this case, if we had waited until now to execute the roll-up, we would have received and additional $4.30 ($51.30 - $47 = $4.30). However, we must ask if that amount of additional profit was worth the risk of holding the $290 call while the stock climbed all the way to $380. Our first goal as option traders should be good money management and we need to do all we can to avoid the downside risk. Even though this example worked in our favor, there’s nothing that says it should. This stock could easily have moved against us at some point, leaving us with a $58 loss if we had never rolled up. That’s why good option traders roll up frequently. If there were no bid-ask spreads or commissions there would be no difference between rolling up frequently or infrequently. But if we wish to protect profits and reduce the risk of holding the stock, most option investors feel that the small losses from the bid-ask spreads and commissions are worth the reduction in risk that frequent roll-ups provide.
Long Puts
We’ve covered the basics of call options in detail. Once you understand the reasons for buying calls, you’ll automatically understand the reasons for buying puts. All of the benefits that apply to calls apply to puts – just in the opposite direction. But just to make sure you’ve got the concepts, let’s run through an example with puts.
Assume that your outlook on Google has turned from bullish to bearish. In fact, at the time that’s exactly what was happening. The stock was trading at $340 and on a quick, downward spiral from the recent high of about $390 (with the all-time high up over $475). This was due to negative outlooks issued by the company as well as analyst downgrades.
Let’s assume you are speculating on a short-term fall. If you wish to capitalize on the bearish outlook by shorting 300 shares of stock, you have unlimited upside risk. In addition, you’re going to have a large margin requirement (roughly $25,000) to short 300 shares. And if the stock rises past the price where you shorted it, you’ll end up with maintenance calls, which means you’ll have to send more money to your broker in order to keep the short position open.
Rather than shorting such a volatile stock, you can buy a put option. Because long puts give you the right to sell shares of stock they become more valuable if the underlying stock falls sufficiently. When you buy a put option, you are long the asset, which means you can only lose the amount you put into the trade. The put call-parity equation showed us that a long put is identical to short stock position plus a long call (P = – S + C) and it is the implicit long call in a put option that protects the put buyer from unlimited upside risk.
Table 8-9 shows the March and April quotes at the time:
Table 8-9
You can see that Google was trading for about $340. Just as with call options, there is a question you must answer before deciding which strike to buy. That is, are you expecting a slow fall or a fast, aggressive one? If the answer is slow, you should buy intrinsic value and find a relatively high strike (preferably a 0.80 to 0.85 delta). However, if you expect that it will be a fast, aggressive fall then you may opt for the at-the-money put. Because stock prices tend to fall much faster than they rise, the decision to buy an at-the-money put may be warranted in more cases than the at-the-money call. In addition, because volatility tends to rise quickly when prices are falling the at-the-money put will get a boost from that as well.
Let’s assume that you decide to buy the three April $340 puts (42 days until expiration) by placing the following order:
Buy to open, three contracts, Google April ’06 $340 puts (GGDPH) at market (limit)
If your order is filled at the $22.90 asking price, it will cost 300 * $22.90 = $6,870 and that is the most you could ever lose on the position.
During that same day, you can see that Google fell over eight points to $334.92 thus making the $340 put worth $24.40 as shown in Table 8-10:
Table 8-10
If you decided to close the three contracts at this time, you would enter the following order:
Sell to close, three contracts, Google April ’06 $340 puts (GGDPH) at market (limit)
If the order is filled at the $24.40 bid then you purchased for $22.90 and sold for $24.40, thus profiting by $1.50 * 300 = $450.
The roll-up strategy we used for calls can also be applied to long puts as a roll-down. With a roll-down, you will sell your long put and simultaneously buy a lower strike put thus collecting a credit (since the higher strike put that you are selling must be more valuable). All of the principles and advantages we discussed for calls can be applied to puts.
Options create different sets of risks and rewards for investors and traders. It is up to the investor to decide which is best for him at the time. In the previous example, we showed that you could have captured a $1.50 profit on the three puts; however, the short stock seller would have collected $339.69 - $334.82 = $4.87. Does this mean the short stock position is better? No, it means there is more risk. At the time, Google had large gap openings (the stock opens at prices much higher or lower than the previous day’s close). If you were short 300 shares and the stock gapped up 10 points the next day you would have an unrealized loss of $3,000. The loss on the long puts would be nowhere near that since they would still maintain some time premium even though they are out-of-the-money. If you’re unsure that an out-of-the-money put on Google maintains significant time premium, check Table 8-10 and you’ll see the $320 put trading for $4.20 and that it is nearly 15 points out-of-the-money. So even though $6,870 was spent for the three $340 puts, it’s highly unlikely that you are going to lose anywhere near that much for a large, upward movement in the stock. Short stock sellers cannot make that assertion.
Options allow you to pick and choose which sets of risks you want to take. Before you put your money into long or short stock positions, be sure your account can handle significant adverse moves. No matter how small the probability may seem, large moves are more likely than you might suspect. On Friday, May 1, 1998 EntreMed (ENMD) closed a little over $12. Monday morning it opened at $83. If you are in doubt as to whether your account can withstand such adverse price swings then long calls and long puts will add a little certainty to a very uncertain world.
Key Concepts
1) Long options (calls and puts) provide protection, leverage, and diversification.
2) Buy 0.80 to 0.85 deltas if using long calls or long puts as long stock or short stock substitutes.
3) If you are willing to buy $10,000 worth of stock you should not put that much money into the options. Instead, buy options representing the same number of shares you are willing to hold.
4) To better diversify your portfolio, try to put a similar dollar amount into each option position.
5) Roll-up call options and roll-down put options when the proper opportunity arises.
Nov
23
Rolling with Call Options
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Rolling with Call Options
Options create tremendous possibilities for investors – far more than what is already apparent from the preceding chapters. The real power of options comes from our ability to alter risk-reward profiles as prices change and that is something you cannot do with stock alone. To demonstrate, let’s go through another long call example but this time we’ll show you the roll-up strategy. In the last chapter, we talked about the roll-up for covered calls, but let’s see what it can do for those holding long calls.
You are a long-term investor who is bullish on Google (GOOG) and wishes to buy 100 shares on August 8, 2005. Table 8-5 shows the stock was trading for about $293, which means it would cost $29,300 for the 100-share lot:
Table 8-5
Rather than put that much money into one stock, you could, instead, just buy one call option. However, notice that the prices are expensive in terms of total dollars as the cheapest one (Jan. $300) is $53.30! This is due to the high volatility of Google along with the fact that there are nearly 1.5 years until expiration. This is one of those times that you may wish to buy a strike closer to at-the-money. Let’s assume we decide to buy the $290 call for $58, or $5,800 per contract to control 100 shares over the next 1.5 years. All you have to do is place the following order:
Buy to open, one contract, Google Jan. ’07 $290 call (OQDAR), at market (limit)
Once the order is filled, you are now long one contract and have the right to purchase Google at any time for $290 per share. Of course, your goal as an option trader is to simply trade the contract and never actually buy the shares of stock. For example, on September 12, just 35 days later, the stock had moved up sharply to $308.25 and the $290 call was bidding $64.20:
Table 8-6
You could sell the contract to close and take your profits. If you choose to do this, you would place the following order:
Sell to close, one contract, Google Jan. ’07 $290 call (OQDAR), at market (limit)
You bought the contract for $58 and sold for $64.20, which is a profit of $6.20 ($620 per contract), or $64.20/$58 = 1.107 = 10.7%. Had you purchased the stock, you would have paid $293.07 and sold for $308.25, which is a profit of $15.18, or 5.2%. Once again, this clearly shows that the stock trader’s total profits are greater but represent a lower rate of return.
However, selling the option at the first sign of profit is usually a mistake. We’re not saying to never take profits but the fact is that trends generally last much longer than we expect. If you sell at the first opportunity for a profit, you will usually regret the sale at a later date no matter how many times people tell you, “You can’t go broke taking a profit.” The truth is that you can go broke taking profits if you tend to take them too early. A lot of tiny profits can easily be overcome by one single loss. Option losses will always occur, so it is up to you to allow your profits to run if you want to survive over the long run. This presents a dilemma though. After all, you are staring a sizable profit in the face. Does it really make sense to do nothing? You can do a little of both; you can take some profits and stay in the position by doing a simple hedging technique called a roll-up. If you are long a call option, you execute a roll-up by selling your current option and simultaneously buying a higher strike option.
For example, you can place an order to sell the $290 call and simultaneously buy the next higher strike, which is $300. To place this roll-up, you would simply enter the following pair of orders to be executed simultaneously:
Sell to close, one contract, Google Jan. ’07 $290 call (OQDAR) and simultaneously
Buy to open, one contract, Google Jan. ’07 $300 call (OQDAT) at market (limit)
One of the nice features of roll-ups is that they always produce a credit to the account since lower strike calls are always more expensive than higher strike calls (Pricing Principle #1 from Chapter Two). Because you are selling the lower strike (more valuable) and using some of that money to buy a higher strike option (cheaper), you will always get a net credit to the account. Table 8-6 shows the $300 strike was trading for $59.50 so in this case, you’d get a credit of $4.70:
Sell $290 call = +$64.20
Buy $300 call = -$59.50
Net credit = $4.70
If you were filled at the above prices, you would be long one $300 call plus have $4.70 * 100 = $470 sitting safely in cash. You have effectively “taken some money off the table” but still control 100 shares. You have now spent a total of $53.50 as shown by the total transactions:
Buy $290 strike = - $58
Sell $290 strike = +$64.20
Buy $300 strike = -$59.50
Net debit = $53.30
In other words, you still control 100 shares of Google but now have reduced the amount you have invested from $58 to $53.30. Granted, you own a higher strike which is less valuable than your original $290 strike, but you have done something more important in that you’ve reduced the risk. Every time you roll up, you slowly chip away at the cost basis of the option, thus remov