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Dec
8
Laddering Hedging Strategy
Hedging is so versatile that we can even create hedges where we get our money back and actually increase the amount of reward. Using the above example, when you originally sold the 300 shares of stock, you could have swapped it for a higher number of contracts, such as four $70 calls instead of three. This still produces a guaranteed return to your account (although lower) but now adds some leverage if the stock should continue its bullish trend. When the stock hits $75, you could add more leverage and roll up from four $70 calls to say, five $75 calls. When you swap or roll up to a higher number of calls (or down for puts), that’s called a laddering strategy, which implies that you’re changing the risk at each rung or step of the roll-up process. There is no set amount or percentage that needs to be applied. As long as you are rolling up to a higher quantity of long positions, it’s a laddering strategy. Each choice presents a different set of risks and rewards, and it’s entirely up to you which is best.
Selling Spreads Against Stock
Chapter Nine introduced you to vertical spreads. As with all option strategies, they can be applied in unimaginable ways and the vertical spread is a perfect example. How many people would think of selling spreads against a long stock position? And what do you suppose it would do to the shares of stock you own?
The following is a real case study that we used for a client in a private mentoring service. The client had 500 shares of WMT at $53 and it was now $56.50. He felt the stock was going to trend sideways for some time and may even fall substantially. He was obviously afraid of losses but didn’t want to pay for the put. Is there an option strategy we can develop that will profit from a sideways stock price and protect the downside risk? Table 10-7 shows the actual option quotes at the time:
Table 10-7: Wal-Mart Option Quotes
We purchased five puts to protect the downside risk he feared. In order to generate enough cash to pay for the put and provide a return in the event the stock price moved sideways we sold 10 – twice as many – $55/$60 vertical call spreads:
Buy 5 $50 puts at 0.55 = -$275
Sell 10 $55 calls at $3.20 = +$3,200
Buy 10 $60 calls at 0.85 = - $850
Net credit = +$2,075
Figure 10-8 shows the effect of the previous three transactions against the long stock:
Figure 10-8
The long puts have completely protected the downside risk, and the sale of the vertical call spreads generated enough of a credit to shift the entire profit and loss curve above zero and create substantial profits if the stock price stays still as projected. As a bonus, the investor still maintains all of the upside potential. We must remember that these benefits did not come for free. If we overlay the original stock position, we can see the tradeoffs clearly in Figure 10-9:
Figure 10-9
Figure 10-9 shows that the investor hedged all of the downside risk and will profit nicely if the stock price stays still, which is exactly in line with his outlook. He accomplished this at the expense of giving up some (not all) of the upside potential. He has sacrificed the very best profit potential in exchange for a guaranteed a return on his money and still has the opportunity to earn more money if the stock price rises. The best news is that similar vertical spreads can be sold month after month, which allows the investor to continually shift the profit and loss curve higher, protect his downside, and still have the potential for unlimited gains.
What would happen if the investor sold 20 spreads instead of 10? Figure 10-10 shows the effect of buying the five puts but selling 20 $55/$60 vertical call spreads:
Figure 10-10
This type of a strategy can be used if the investor is far more bearish on the stock and willing to give up much more upside in exchange for more profit to the downside. What if the investor wanted to actually profit from a fall in the stock’s price? He can do that, too, by purchasing 10 puts rather than five. Figure 10-11 shows the effect of buying 10 puts and selling 10 $55/$60 vertical call spreads:
Figure 10-11
The purchase of 10 puts actually allows the investor to profit to the downside at the expense of profit at the center and to the upside. The possibilities are endless for those who take time to explore the world of options. As stated at the beginning, this chapter is not designed to be a full course on hedging techniques as an entire book could be written on that subject. Instead, we wanted to introduce you to advantages that options provide by allowing you to buy and sell risk. As you continue to learn about options, you will find that all other strategies will be self-evident if you understand the fundamental concepts presented in this book.
In order to succeed in the financial markets, you must invest relatively large dollar amounts and let the profits run. However, we also know that our risk-averse natures won’t allow that to happen. We feel much more comfortable placing small bets and being assured that it is the most we can lose – even if it means we will most likely lose it. By trying to avoid risk, most investors and traders actually place their money in maximum jeopardy.
All hope is not lost. In order to reach for bigger profits, you must remove the fear of loss. You must hedge your bets and bet against yourself. And the only way to do that is with options, since they are the only asset that allows you to buy and sell risk. Once you’ve locked yourself into a guaranteed winning position, hang on. Remember that trends last longer than we expect. Keep the position alive but continue to take profits and cover risk by additional hedges. Options remove fear. Use them conservatively to make money.
Edgar Watson Howe, a famous American writer, once said, “A good scare is worth more to a man than good advice.” If you learn to hedge your trades, you’ll never have to go through a good scare, and that is the best advice that the Options University can give.
Dec
7
Let’s use eBay as an example. Between October and December 2002, eBay made a phenomenal run from around $50 to $70, which you can see in Figure 10-1:
Figure 10-1
Assume you purchased this stock during the uptrend at $55; it would certainly be tempting to take the profit at $70. After all, eBay made a substantial move and it’s sensible to think it will pull back. But if you accept the fact that you’re probably not at the very top, the more prudent move is to stay in the trade but protect the existing unrealized profits. We can do that by utilizing a stock swap strategy. It’s very simple and here’s what you do: Sell all your shares and buy an equivalent share amount of call options. In effect, you are “swapping” your stock for calls.
Incidentally, these two trades, selling your stock and buying calls, can be executed simultaneously through most brokers. Let’s assume you originally purchased 300 shares of eBay at $55 and it’s now $70. That means you have an unrealized profit of $15, or $4,500. To execute the stock swap, you’d sell your 300 shares and simultaneously buy three calls. If our goal is to get a lot of cash off the table, we would probably consider buying the at-the-money $70 call. The actual quote for an eBay January $70 call at that time was $2.75.
Selling your shares will bring in $21,000 (300 * $70) cash and buying 3 $70 calls costs $825 (300 * $2.75), which means you get a net credit of $20,175 cash to your account. The shares originally cost $16,500 ($300 * $55) so you’ve now locked in a profit of $20,175 - $16,500 = $3,675, or 22%. But not only did you lock in a profit, you are still effectively long 300 shares of stock. Any increase in eBay only increases your profit, and there is no risk of losing your original principal; it’s sitting safely in the money market. Figure 10-2 shows graphically the effect of our hedge:
Figure 10-2
The straight shaded line represents the original long stock position at $55. The solid line is our new long $70 call including the net credit we received from selling the stock. Effectively then, we own 300 shares of stock at a cost better than free; we cannot lose and we may make more. Notice that the trade eliminates the downside risk at the expense of reducing the upside potential, which fits our definition of hedging. In other words, for all stock prices above the $67.25 crossover point we would be better off holding the stock as its profit and loss curve sits higher on the chart. But it’s not the fear of lost opportunity that drives us to get out early; it’s the fear of loss and the stock swap hedge removes all that fear. Now we’ve changed our perception of the trade and made it less risky. We can now stay in for much longer than we normally would and possibly catch a huge homerun trade.
Notice, too, that the hedge does not rely on timing. With the stock at $70, are we at the top of a peak? Statistically speaking, probably not. It’s much more likely that we didn’t sell at the highest point. However, our risk-averse nature prods us to take the sure $15 profit and run. Rather than take the $4,500 gain, we hedged the position and captured a sure gain of $3,675. We now can gamble in hopes that we were not at a peak and try for some real money.
As the stock rises, we would continue to roll the calls up as discussed in Chapter Eight. Each roll-up generates more cash and shifts the profit and loss curve higher. For example, assume that eBay moves from $70 to $75 and we roll the position up for a net credit of $3.50. While this is a hypothetical credit, we can use some option-pricing theory to justify it. To roll the position up you would sell the $70 call to close and simultaneously buy the $75 call to open. Now, just look at that trade disregarding the “opening” or “closing” designations. The trade is selling the $70 call and buying the $75 call – a short $70/$75 vertical call spread.
What is this spread worth? To make it easier, imagine that you were long the $70/$75 spread with the stock at $75. We know it must be worth more than $2.50 (the halfway point) but less than the full $5 difference in strikes. So to buy this spread would cost somewhere between say $2.50 and $4.50 depending on how much time is remaining, which is why we assumed $3.50. Therefore, if you sell this spread, you will receive a credit in the same amount. If we were looking at actual quotes, you’d find that the roll-up must be executed at a price very close to this. Again, this is why it is so important to understand the fundamentals presented in this book as the strategies will become second nature to you.
If you roll up for a net credit of $3.50 on 300 contracts, that will generate an additional 300 * $3.50 = $1,050 to your account. You had locked in $3,625 from the first roll to the $70 call and have now locked in another $1,025 from the second roll to the $75 call for a total guaranteed profit of $3,625 + $1,025 = $4,650. However, because you are still effectively long 300 shares (long 3 $75 calls) you will continue to profit if the stock price should continue to climb. The profit and loss graph will shift from the shaded line to the bold line as shown in Figure 10-3:
Figure 10-3: Effect of Rolling from $70 Call to $75 Call
Notice that the new bold line has been shifted higher as shown by Arrow A representing the higher guaranteed return. No matter how low the stock’s price may fall you are now guaranteed to receive $4,650. And if the stock price rises, you will benefit in an unlimited way. The tradeoff is that the bold line has been shifted to the right as shown by Arrow B. For all stock prices above the $73.42 crossover point, the previous profit and loss curve would have performed better. But notice the relatively small space lost by the shift at Arrow B compared to the relatively large space gained by Arrow A. It is a small sacrifice of upside potential in exchange for a much higher guaranteed return. You have hedged your investment and it was done without losing control of the 300 shares.
What if you were more concerned about protecting profits? We could use other hedging strategies as well. For instance, when you rolled up to the $75 call, you could also sell the $80 call, thus creating a $75/$80 vertical call spread. Assume that you could sell the $80 for $1. Selling three of these calls would generate an additional 300 * $1 = $300 profit but it would also limit your upside potential. If you rolled up to three of the $75 calls and sold three of the $80 calls then the profit and loss curve in Figure 10-3 would look like the one in Figure 10-4:
Figure 10-4: Effect of Rolling Up to Three $75 Calls and Selling Three $80 Calls
Figure 10-4 shows that you have increased your guaranteed return by another $300 at the expense of limiting your profits for all stock prices above $80. If you don’t think the stock price will rise above $80, why not sell that part of the range to someone else in the market? Try doing that with stock.
If the idea of completely capping your upside potential is unappealing, then you can hedge that bet, too, and roll up to three of the $75 calls but perhaps sell only two of the $80 calls. Your profit and loss curve would then look like Figure 10-5:
Figure 10-5: Effect of Rolling Up to Three $75 Calls and Selling Two $80 Calls
The bold line has shifted higher by $200 from the sale of the two $80 calls at $1 each. Because you control 300 shares and have sold off 200 shares, you are still net long 100 shares for all stock prices above $80 and that’s why the profit and loss curve doesn’t flatten out like it did in Figure 10-4. The possibilities are endless once you understand the fundamentals of options.
Figure 10-6 shows why hedging is usually the best choice. Trends usually last longer than most people expect and eBay was no exception. The arrow shows the point where we were considering selling the stock. But the stock swap and subsequent roll-ups allowed us to capture a guaranteed profit and hold on through August to the price of $110 (eBay had a 2:1 split at this time, so Figure 10-6 only shows a $55 price):
Figure 10-6
No matter where you may decide to completely exit this trade, you are better off than if you sold the stock at $70. The stock swap and roll-up hedges allowed us to capture a profit of over $10,000 with no downside risk of principle. The cash from the stock swap and roll-ups was always sitting safely in money market.
Dec
6
What Kind of Risk Takers Are We?Every day we’re faced with making decisions about risk. You may not realize that you do, but subconscious calculations are always taking place regarding which risks to take and which to avoid. Walking across the street is, technically, risking your life to get to the other side. On one hand, you may think that sounds farfetched, but it is the worst thing that could happen from crossing the street. However, despite the risk, we walk across streets countless times because, intuitively, we know the probability of that worst-case scenario is very, very low. It’s an acceptable risk, so we choose to take it. Depending on the situation, people tend to avoid risk, accept risk, and in some cases, even seek to take risk.
Psychologists have created three general categories to classify these risks:
1) Risk-averse (those who avoid risk)
2) Risk-neutral (those who accept reasonable risks)
3) Risk-seeking (those who accept high-risk situations)
You are risk-averse if you buy insurance and you are a risk-seeker if you skydive. You are probably risk-neutral about crossing the street. In most cases, people have different attitudes toward risk and it’s not easy to say if they are risk-averse, risk-neutral, or risk-seeking for a particular event. That is, until it comes to money. When it comes to money, people become very predictable and display a consistent view of risk. It is this view of risk that causes many mistakes in trading. Do you fall into the same category as most people? Here’s how to find out: An eccentric millionaire asks you to choose between the following two choices. You only get to play the game once. Which would you choose?
A) $500 gain for sure
B) Flip a coin and get $1,000 if heads and nothing if tails
Both choices are similar in the sense they have the same long run average. In mathematical terms, they are said to have the same expected payoff, or expected value, which is nothing more than a mathematical long-run average. If you were allowed to play this game thousands of times, you would expect to be up $500 per try regardless of which alternative you choose. Obviously, Choice A always yields $500 with each try. Choice B, on the other hand, yields $1,000 half the time and nothing half the time so, in the long run, you’d be up $500 per try.
A risk -verse person will only take Choice A while risk-seekers will choose Choice B. A risk-neutral person would be indifferent between the two choices.
We Really Despise RiskDr. Robert Anthony said, “Most people would rather be certain they’re miserable, than risk being happy.” Sadly enough, most of the research in the field of behavioral finance shows this to be true. In fact, in 1979, two famous psychology researchers, Daniel Khaneman and Amos Tversky, published an influential paper in The American Psychologist showing our risk-averse natures – and with a remarkable twist. In that study, the researchers gave subjects a choice between the following two alternatives that we saw earlier:
A) $500 gain for sure
B) Flip a coin and get $1,000 if heads and nothing if tails
Most people picked Choice A without hesitation. This was no surprise to the researchers as they were aware of our risk-averse tendencies. However, the researchers added an interesting twist and asked the following intriguing question:
C) Take a $500 loss for sure
D) Flip a coin and lose $1,000 if heads and nothing if tails
By similar reasoning with the first set of choices, the second set encompasses an average loss of $500 regardless of which you choose. The difference here is that Choice C results in a guaranteed loss. Choice D may be a $1,000 loss, but it could also result in no loss, both with equal probability. The two researchers expected that if subjects displayed a risk avoidance behavior as with the first set of questions, they should still avoid risk and accept a $500 loss for sure. But oddly enough, the researchers found that most subjects selected Choice D – they accepted the gamble to try and avoid the loss! This means that investors’ aversion to loss overcomes their aversion to risk. The paradox is that we detest risk so much that we’re willing to take risk to avoid it.
This is a fascinating observation about human nature that demonstrates why it’s so important to hedge trades. If a trade is moving against us, it’s our nature to try to gamble our way out. It goes against our makeup to take the for-sure loss. Likewise, when we have winning trades, it goes against our nature to hang on – we’re too afraid of losing the gains we already have. Hedging your positions prevents both of these behaviors and allows you to capture bigger profits.
How many times have you heard “you can’t beat the professionals” or “the market makers always win” or other similar phrases? The reason they are basically true is that professionals know how to hedge. Retail investors end up taking the risky side of the bet and are in trades too soon and out too early. They rely too much on timing and direction and end up losing. Add to this our risk aversion and willingness to gamble our way out of losing situations and you have the very reason so many investors and traders miss their goals with investing.
Hedging is a powerful tool and the key to financial success. Options were designed to hedge. It’s now time to discover the option secrets used by professional traders.
Stock Swap
Of all the hedging techniques, this is the probably the simplest and most useful for most traders so it is a great place to start. Unfortunately, it’s also the least used. Anybody who trades stocks needs to understand this strategy
Dec
4
Chapter Nine Answers
1) If you buy a $50 call and sell a $55 call it is a:
c) Long vertical call spread
Whenever you buy a vertical spread, you are always buying the more valuable option. For call options, that will always be the lower strike, which is $50. So buying the $50 call and selling the $55 call is a long vertical call spread.
2) Spreads always involve:
d) Buying of one option and the selling of another of the same type
There are many types of spreads but all of them involve the buying of one option and selling of another.
3) A vertical spread is:
a) Buying one option and selling another within the same month
4) If you are short the $100/$105 put spread you are:
b) Short the $105 put, long the $100 put
Short vertical spreads are always executed by selling the more valuable strike. For puts, that will always be the higher strike put. So if you are short the $100/$105 put spread, you are short the $105 put and long the $100 put.
5) If you buy the $100/$105 call spread you are:
c) Long the $100 call, short the $105 call
Whenever you buy a vertical spread, you are always buying the more valuable option. For call options, that will always be the lower strike, which is $10050. So buying the $50 call and selling the $55 call is a long vertical call spread.
6) Vertical spreads have:
d) Limited risk, limited reward
7) If you buy the $50/$55 vertical call spread for $3.50, the breakeven point is:
c) $53.50
If you buy the $50/$55 call spread you are effectively buying the $50 call for $3.50. The sale of the $55 call just helps to reduce the cost of the more valuable $50 call. If you pay $3.50 for the $50 call then the breakeven point is $50 + $3.50 = $3.50.
The maximum a vertical spread can be worth is: b) The difference in strikes
The very most any spread can be worth is the difference in strikes.
9) If you buy a low strike option and sell a higher strike option of the same type and same expiration it is a:
c) Vertical bull spread
A vertical bull spread is always constructed by purchasing the lower strike option and selling a higher strike option.
10) Long vertical spreads are always constructed by:
b) Buying the more valuable option
Whenever you buy the more valuable option you have a long vertical spread
11) Credit spreads should be used:
b) When the risk is greater than the corresponding debit spread
Credit spreads should be used when it provides a greater reward than the corresponding debit spread.
12) If you buy the $70/$75 vertical call spread you have the:
c) Right to buy shares for $70 and the obligation to sell for $75
If you buy the $70/$75 vertical call spread you are long the $70 call and short the $75 call. You have the right to buy shares for $70 and the obligation to sell shares for $75.
13) Buying the vertical call spread is identical to:
a) Selling the corresponding put spread
14) Debit spreads are used to:
b) Reduce the cost of the long option
One of the motivations for using debit vertical spreads is that they reduce the cost of the long option.
15) Credit spreads are used to:
a) Reduce the risk of the short position
Credit spreads are initiated by selling the more valuable option which subjects you to unlimited risk. Buying the lesser valued option reduces the risk of the short position.
16) If you sell the $30/$35 put spread for $2, the most you can lose is:
b) $3
If you sell the $30/$35 put spread you are short the $35 put and long the $30 put. You have the obligation to buy shares for $35 and the right to sell shares for $30, which leaves you with a $5 loss. Because you were paid $2 for the spread, the most you can lose is $3.
17) ABC stock is trading for $74. What would you expect the value of the $70/$75 vertical call spread to be?
b) More than $2.50
If the stock were at the midpoint of the spread ($72.50) you would expect the $70/$75 spread to be worth $2.50. However, if the stock price were higher than $72.50, you would expect the value of the spread to be worth more than $2.50.
18) If you sell the $80/$85 put spread for $2, what is the breakeven point?
c) $83
If you sell the $80/$85 put then you are short the $85 put, which means the stock can fall by the $2 premium to a price of $83. If the stock is $83 at expiration, the long $80 put expires worthless and the short $85 put is worth the intrinsic value of $2. You could buy back the spread for $2 thus breaking even.
19) If both strikes are in-the-money, what happens to the value of a vertical spread near expiration?
d) Converge to the difference in strikes
If both strikes are in-the-money then the value of the spread converges to the difference in strikes as the time premium slowly decays.
20) The value of a vertical spread tends to change:
d) Slowly over time
The two options counteract each other as the stock price changes so the value of vertical spreads tends to change slowly over time.
Dec
3
Chapter Nine Questions
1) If you buy a $50 call and sell a $55 call it is a:
a) Long horizontal call spread
b) Short horizontal call spread
c) Long vertical call spread
d) Short vertical call spread
2) Spreads always involve:
a) Buying of a put and call
b) Selling of a put and call
c) Buying of a call and buying of a call in a different month
d) Buying of one option and the selling of another of the same type
3) A vertical spread is:
a) Buying one option and selling another within the same month
b) Buying one option and selling another within a different month
c) Selling one option and selling another month and strike
d) Buying one option and buying another
4) If you are short the $100/$105 put spread you are:
a) Short the $100 put, long the $105 put
b) Short the $105 put, long the $100 put
c) Long the $100 put, long the $105 put
d) Short the $100 put, short the $105 put
5) If you buy the $100/$105 call spread you are:
a) Short the $100 call, long the $105 call
b) Short the $105 call, long the $100 call
c) Long the $100 call, short the $105 call
d) Short the $100 call, short the $105 call
6) Vertical spreads have:
a) Unlimited risk, limited reward
b) Limited risk, unlimited reward
c) Unlimited risk, unlimited reward
d) Limited risk, limited reward
7) If you buy the $50/$55 vertical call spread for $3.50, the breakeven point is:
a) $46.50
b) $51.50
c) $53.50
d) $58.50
The maximum a vertical spread can be worth is: a) The strike of the short less the time value
b) The difference in strikes
c) The sum of the strikes
d) The strike of the long plus the time value
9) If you buy a low strike option and sell a higher strike option of the same type and same expiration it is a:
a) Neutral spread
b) Vertical bear spread
c) Vertical bull spread
d) Diagonal spread
10) Long vertical spreads are always constructed by:
a) Buying the lesser valued option
b) Buying the more valuable option
c) Selling the more valuable option
d) Selling the lower strike option
11) Credit spreads should be used:
a) Always because they are better than debit spreads
b) When the risk is greater than the corresponding debit spread
c) When the reward is greater than the corresponding credit spread
d) When there is a short time until expiration
12) If you buy the $70/$75 vertical call spread you have the:
a) Right to buy shares for $70 and the right to sell for $75
b) Right to buy shares for $75 and the obligation to sell for $70
c) Right to buy shares for $70 and the obligation to sell for $75
d) Right to sell shares for $70 and the obligation to sell for $75
13) Buying the vertical call spread is identical to:
a) Selling the corresponding put spread
b) Buying the corresponding put spread
c) Selling the corresponding diagonal spread
d) Buying the corresponding horizontal spread
14) Debit spreads are used to:
a) Reduce the cost of the exercise
b) Reduce the cost of the long option
c) Increase the premium you receive
d) Decrease the risk of early exercise
15) Credit spreads are used to:
a) Reduce the risk of the short position
b) Reduce the cost of the long option
c) Increase the premium you receive
d) Decrease the risk of early exercise
16) If you sell the $30/$35 put spread for $2, the most you can lose is:
a) $2
b) $3
c) $4
d) $5
17) ABC stock is trading for $74. What would you expect the value of the $70/$75 vertical call spread to be?
a) $2.50
b) More than $2.50
c) Less than $2.50
d) More than $5.00
18) If you sell the $80/$85 put spread for $2, what is the breakeven point?
a) $78
b) $82
c) $83
d) $87
19) If both strikes are in-the-money, what happens to the value of a vertical spread near expiration?
a) Converge to the difference in strikes less the premium
b) Converge to the midpoint of the strikes
c) Converge toward zero
d) Converge to the difference in strikes
20) The value of a vertical spread tends to change:
a) In a steady, reliable way toward the difference in strikes
b) Quickly for longer-term but not shorter-term spreads
c) Quickly over time
d) Slowly over time
Dec
2
How Much Time?
When investors and traders learn about spreads one of the first questions asked is how much time to buy or sell. This is a very tough question to answer for spreads. As with any strategy, each set of strikes and time frames creates a unique set of risks and rewards. If both strikes are in-the-money then shorter time frames provide a better chance for the spread to expire with intrinsic value. In other words, if both strikes are in-the-money then shorter terms vertical spreads are less risky. As the risk-reward relationship shows though, these spreads may not provide a very big reward. If you wish to increase the reward for any given set of strikes then you will need to increase the expiration date.
For instance, assume ABC stock is trading for $54 and the one-month $45/$50 vertical call spread is worth $4.50, which means the most you can make is 50 cents per spread. A longer-term contract will trade for less than $4.50 thereby providing a larger reward. Why is this? It is riskier to hold with more time remaining. If the $45/$50 vertical call spread were to expire right now then the spread would be worth the full $5 value. However, as you increase the time remaining on the spread then that just provides a chance for the spread to fall out-of-the-money so it becomes riskier.
On the other hand, if you are buying out-of-the-money strikes then buying longer time frames will give you a better chance for the strikes to expire in-the-money. Providing a better chance for intrinsic value is the same as saying it is less risky, and that means the spread will not provide as much reward.
The trick is to balance the risk and reward to suit your tastes. In our Google example, most traders would never use a vertical spread with that much time remaining. However, by selling that much time, it allowed us to get strikes very deep-in-the-money and still provide a very nice return. If we would have considered a shorter time frame, we would find that the reward was less than $3. It’s all about risk-reward tradeoffs and it is up to the investor to decide which to buy or sell.
When it is time to exit the spread, you simply enter the reverse set of transactions that got you into the trade in the first place. For example, 35 days later, Google was trading for roughly $308. If you wanted to close the spread, you would enter the closing transaction in one of two ways depending on your broker’s platform:
1) Buy the Google January $250/$260 vertical put spread at market (or net debit limit)
2) Buy to close, Google Jan. $260 put and simultaneously sell to close the Google Jan. $250 put at market (or net credit limit)
Figure 9-9 shows that 35 days later the $260 put could be purchased for $20.90 and the $250 put could be sold for $17.40 for a net debit of $3.50:
Figure 9-9
This clearly demonstrates that despite a positive move in the underlying stock from $293 to $308 that the spread would not be profitable. The spread was sold for $3.00 and purchased back for $3.50, a loss of 50 cents per spread. The reason this happened is because there are still 494 days remaining until expiration and a $15 move in a stock like Google is not significant relative to that amount of time remaining. If there were a shorter amount of time remaining, say three months, then the spread would definitely be profitable. But at this time, investors and traders were bidding up the value for the out-of-the-money $260 put for insurance, and that created the 50-cent loss. In other words, on a net basis, the amount of time premium owed on the short $260 put increased, which is bad for you as the seller.
The main reason we explained this is to emphasize the fact that spreads need time to pass before they become profitable. Many traders who are short-term in nature are disappointed to find that the stock has moved in their favor yet the spread is at a loss. So be aware that you will need to wait until very close to expiration before you realize the full value of the spread.
Vertical spreads allow you to profit on outlooks covering specific ranges of stock prices. They are also a perfect solution for times when you find options that you may consider too expensive or too risky. Option trading goes far beyond the purchase of a call or put to capitalize on a directional outlook. The main purpose of this chapter is to allow new investors and traders a glimpse into the world of options trading at a higher level. Options create opportunities that cannot be found with stock or any other asset. Once you master the concepts presented in this book a new door will open and you will find that vertical spreads are just one of many fascinating opportunities available to you.
Key Concepts
1) Vertical spreads have limited risk and limited reward.
2) Vertical spreads have a bullish or bearish bias.
3) Vertical spreads allow investors to buy long options for less money (debit spreads). They also allow investors to sell options for less risk (credit spreads).
4) Buying the call spread is identical to selling the corresponding put spread and vice versa.
5) The higher the reward that a vertical spread offers the riskier the position.
6) Spread values tend to move slowly. If you wish to collect the full value of the spread (assuming it has moved in your favor) you must wait until very close to expiration. Otherwise, you will receive less than the maximum reward.
Dec
1
Risk and Reward Revisited
Many traders who see spreads as in this example believe that it is a “terrible” or “unfavorable” risk-reward ratio. They reason that it doesn’t make a lot of sense to put $7.00 at risk in exchange for a $3.00 maximum profit. If you remember back to our lesson on risk and reward, you should realize that the reason the market has bid this spread to a relatively high level is because the stock price is $293 and is well above the short $260 strike. If the stock price rises, stays still, or even falls to $260 the trader will make the full $10 on the spread ($3.00 profit). When viewed in this light, you can see why the market is willing to pay a relatively high $7 price in exchange for a relatively low $3 reward. It is not an unfavorable risk-reward ratio but, instead, a reflection of the relatively low risk in the position.
You can verify this by considering a different vertical spread. Rather than selling the $250/$260 vertical spread, you could sell a set of strikes that are closer to the current stock price, thereby accepting more risk. For example, you may decide to sell the $280/$290 vertical put spread instead. You could sell the $290 put for the $38.50 bid and buy the $280 put for the $34.50 asking price for a net credit of $4.00. The profit and loss diagrams of the two vertical put spreads are compared in Figure 9-8:
Figure 9-8: Short $250/$260 Vertical Put Spread (Shaded Line) Compared to Short $280/$290 Vertical Put Spread (Bold Line)
Figure 9-8 shows that selling the $280/$290 vertical put spread (bold line) does have more reward than the short $250/$260 vertical put spread ($4 versus $3). Selling the $280/$290 vertical put spread also has less of a downside ($6 versus $7). On the surface it seems like you get the best of both worlds – more reward, less money to lose. However, you must remember that we are not comparing the same strike prices, which means there are different sets of risks and rewards. You are more likely to end up with losses on the $280/$290 spread because the short $290 strike is very close to the current stock price of $293. The $250/$260 spread will not fall into losing territory until the stock price hits $260, which is $30 away from the current price, which means it is less likely to happen. The $280/$290 vertical spread is riskier and that’s why it has a higher reward.
Don’t get trapped in believing that the spreads with the highest rewards and the lowest downside are superior. They are simply riskier and it is up to you to decide which sets of risks and rewards to take.
As a general rule, if the stock’s price is exactly halfway between two strikes, you will find that the maximum gain and loss will be equal to half the distance of the strikes. For instance, if Google was trading for $295, then it would fall exactly halfway between the $290/$300 strikes. Because there is a $10 difference in strikes, then half that amount, or $5, would be the maximum gain and maximum loss for the $290/$300 vertical spreads (calls or puts). In other words, if the stock’s price is exactly halfway between strikes there is a 50-50 chance that it will make or lose money so the cost will be 50% of the distance in strikes.
If the stock’s price were below the halfway point, you would find that the maximum gain for the bull spreads is greater than $5 (and the maximum loss is less than $5). Why does the maximum gain rise as the stock price falls further away from the strikes? If the stock price falls, the long call spread (bull spread) is becoming more out-of-the-money and is therefore riskier, so it will trade at a discount from $5. If you can buy the $10 call spread for less than $5 then you must end up with more reward. The long put spread, on the other hand, becomes more in-the-money as the stock price falls and trades at a premium to $5 since it is becoming less risky. Therefore, if you sell this spread (bull spread), you will be receiving more than $5, which is your reward. So the further below the stock price is from the strikes of the bull spreads, the riskier they become and the more reward they offer.
The opposite is true if the stock price rises above the halfway point of the strikes for the bull spreads. As the stock price rises, the long call spread (bull spread) is becoming more in-the-money and is therefore less risky. It will therefore trade at a premium to $5 and consequently have a reward less than $5. On the other hand, as the stock price rises, the long put spread becomes more out-of-the-money, which means it is worth less than $5. Therefore, if you sell the put spread (bull spread) your reward will be less than $5 just as if you had purchased the call spread. The further above the stock price is from the strikes of the bull spreads, the less risky they are and the less reward they offer.
Figure 9-8 confirms these risk-reward relationships and shows the $250/$260 vertical spread has less reward than the $280/$290 vertical spread. Why? Because the stock price is so much further above the $250/$260 strikes, which makes these strikes trade at a premium (gives you less reward) and makes the put spreads trade at a discount, which gives you less reward.
Let’s work through one quick example to be sure you understand how this principle applies to vertical spreads. Assume that ABC stock is trading for $47.50. What do you suppose the $45/$50 vertical call spread will cost? It should cost $2.50 and therefore have a reward of $2.50. However, if the stock is $55 the vertical call spread will cost more than $2.50 and offer a lower reward. The reason is that it is getting less risky since the call strikes are in-the-money. As the risk decreases, the price goes up. If the stock price is $40, the vertical call spread will cost less than $2.50 since the calls are out-of-the-money and the spread is relatively riskier. As the risk increases, price decreases.
Once you understand how these relationships apply to the long vertical call spread, the answers are opposite but work for similar reasons for the long vertical put spreads. For instance, if the stock price is $55, the long $45/50 vertical put spread is riskier since both strikes are out-of-the-money. It will therefore cost less and offer more. On the other hand, if the stock price is $40, the long $45/50 put spread is in-the-money and is therefore less risky. It will cost more than $2.50 and offer a lower reward.
Price Behavior of Vertical Spreads
Vertical spreads converge to a specific value as expiration nears. What is that value? Think back to the mechanics of long calls and puts. As expiration nears, all in-the-money options converge to intrinsic value while all out-of-the-money options converge toward zero. In the same way and for the same reasons, vertical spreads converge to either intrinsic value or zero.
For example, let’s go back to our $250/$260 vertical call spread that was trading for $7.20. With the stock at $293, both of these calls are in-the-money, which means the spread must converge to the $10 difference in strikes as time goes by. If the stock price remains at $293, the long $250 call is worth the intrinsic value of $43 at expiration while the $260 call is worth the intrinsic value of $33. Since you are long the $250 call you will collect $43; because you are short the $260 call you will owe $33 and your net gain will be $10. After subtracting the $7.20 cost, your profit is $2.80. As long as the stock price is above the short strike ($260) at expiration this spread will slowly start to increase to a maximum value of $10.
Why is the spread not worth $10 today? The answer is time value. The long call has time value of $37.40 ($80.40 premium - $43 intrinsic value). The short call has a time value of $40.20 ($73.20 premium - $33 intrinsic value), which is an amount you owe. Because you owe $40.20 of time value and own $37.40 worth of time value, the net amount you own is $40.20 - $37.40 = $2.80, which is exactly the amount of your maximum gain. Your maximum gain is simply earned by the passage of time. As the long and short time values fall toward zero, the amount you owe is reduced by a net of $2.80 and that’s when the spread will converge to the full $10 difference in strikes.
What if the stock price is between $250 and $260 at expiration? In this case, the vertical spread will converge on the intrinsic value of the long call. For example, if the stock is $258 then the long $250 call converges on the $8 intrinsic value while the short $260 converges toward zero since it is out-of-the-money. You will collect $8 and owe nothing for a gain of $8. After subtracting the $7.20 cost, you are left with an 80-cent profit.
If the stock price is less than $250 at expiration, both the long and short calls will converge toward zero since they are both out-of-the-money. As time passes, the value of the spread will therefore fall toward zero. The same reasoning exists for the vertical put spreads.
The important point to understand is that vertical spreads do not respond quickly to changes in the stock’s price. The reason is that vertical spread consists of a long and short option. As the stock price moves in any direction, one option increases in value while the other loses value so the net change to the vertical spread is small. Further, the time value does not become zero until expiration so the full value of the spread cannot be realized until expiration. (It is also for these reasons why it is not a big risk to enter a “market” order.) As with any option position, you can certainly close it prior to expiration; however, do not expect it to be worth the maximum value. While vertical spreads do allow investors and traders to enter into option positions cheaply, they do come with a drawback in that you should not expect to exit with a profit unless a very favorable price change has occurred relative the time remaining on the option.
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.