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Options Trading Mastery: An Imaginary Spread Scenario

admin — Fri, 01 Jan 2010 17:29:27 +0000

We are going to put together an imaginary spread scenario and set it in real life events. Consider that, in October, you begin to hear about IJK stock. It looks interesting, so you use a variety of sources to learn about it. (News, charts, outside analysts, Internet research, etc.) From your investigations, you decide that this stock is poised for a strong upward move and you would like to take advantage of it. Each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.
Now is the time to investigate IJK spreads. Since you are bullish on the stock, you look into the bullish plays of the call spreads and the put spreads. You check the pricing of both since you know that implied volatility and time decay affect your purchase and selling price if you decide to sell out the spread before expiration.
Imagine that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide that you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. This is the Nov. 50-60 spread. The spread’s cost is $3.50, which means you pay $3,500 for the trade. This is inexpensive when you consider that 1,000 shares of IJK stock would have cost you $50,000! You will now wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.
If the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you will lose the $3,500 that you paid for the spread. If the stock begins to move up, you will recoup your investment and move into profits. When the stock has moves up to $3.50, you are at the breakeven point. Every money advance after that represents profit.
At any time until expiration, you can sell out of the spread, but what you receive for the price are influenced by implied volatility and time decay. That will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3,500 investment is $6,500.
You paid $3,500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6,500 profit, which is a 186% return. If you had invested $50,000 for 1,000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.
For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

Options Trading Lessons: Vertical Spreads

admin — Fri, 01 Jan 2010 05:25:59 +0000

There are two main types of vertical spreads. There is the vertical call spread and the vertical put spread. Each spread allows you to do two things. First, you can buy it, making you long the vertical spread. Second, you can sell it making you short the vertical spread. Both can be employed to take advantage of directional stock plays. When we use the term ‘directional stock play,’ we refer to using vertical spreads to capitalize on anticipated stock movements either up or down.
A bull spread is used when the investor feels that a stock is most likely to go up. As we recall, ‘bullish’ means to have a positive outlook on a stock’s future movement. There are two ways to set up a bull spread. The first is with the use of calls. In this case, a bullish investor would buy a vertical call spread (bull call spread). This is accomplished by buying a call with a lower strike price and selling a call with a higher strike price.
The second way to construct a bull spread is with the use of puts. A bullish investor could sell a vertical put spread (bull put spread) hoping to profit from an increase in the stock’s value. The investor would sell a put with a higher strike price and buy a put with a lower strike price. Let’s take a look at how the P&L chart of a Bull Spread looks below.
To recap, if you feel a stock will be increasing in value, you may put on a bull spread by either buying a vertical call spread (bull call spread) or selling a vertical put spread (bull put spread)
A bear spread, however, is used when, you the investor, feels a stock is likely to trade down. Remember, ‘bearish’ means that one’s outlook on the future movement of the stock is negative. To take advantage of this expected downward movement, the investor would put on a bear spread. This can be done in either of two ways.
First, the investor can do it using puts. The purchase of a vertical put spread (bear put spread) can be accomplished by purchasing a put with a higher priced strike and selling a put with a lower priced strike.
The second way an investor can construct a bear spread is by using calls, specifically, by selling a vertical call spread (bear call spread). You do this by selling a call with a lower strike price and purchasing a call with a higher strike price.
So if you think that a stock is likely to decrease in value, you sell a vertical call spread (bear call spread) or purchase a vertical put spread (bear put spread). Let’s take a look at the P&L diagram for a Bear Spread below.
Finally, there are two fundamentals that are universal to all vertical spreads. These fundamentals are critical to understanding the foundation of the vertical spread strategy: (1) you can determine a vertical spread’s maximum value by taking note of the difference between the two strikes and (2) vertical spreads have intrinsic value.

Options Trading Mastery: Vertical Spread Test Scenario

admin — Thu, 31 Dec 2009 18:12:21 +0000

Let’s put together what we’ve been talking about, develop an imaginary spread scenario and set it in real life events.
In October, let’s say that you begin to hear about IJK stock. It looks interesting, so you then use a variety of sources to learn about IJK: news, charts, outside analysts, internet research etc. From your investigations you decide that this stock is poised for a strong upward move and you’d like to take advantage of it.
However, each share is $50.00 and you question whether you want to put out the capital for enough shares to make the trade worthwhile.
Now is the time to investigate IJK spreads. Since you are bullish on the stock, you investigate the bullish plays of the call spreads and the put spreads. You check the pricing of both since you are aware that implied volatility and time decay will affect both your purchase price and your selling price if you decide to sell out the spread before expiration.
Let’s say that you set the spread’s maximum potential gain at $10.00 using our formula. Then you decide you want to buy a call spread, so you buy 10 IJK Nov. 50 calls and sell 10 IJK Nov 60 calls. The spread is called Nov. 50-60. The spread’s cost is $3.50, which means you pay $3500 for the trade, inexpensive when you consider that to purchase 1000 shares of IJK stock would have cost you $50,000! Now, you wait and follow the stock price of IJK. If you hold the position to expiration, you face the following losses or gains.
First, if the stock does not move up as you expected and stays at $50 or decreases in value, your spread is worthless and you lose the $3500 that you paid for the spread. Second, if the stock begins to move up, you first recoup your investment and then move into profits. After the stock has moved up $3.50 you are at the breakeven point. Every money advance after that represents profit.
The chart below represents the spread’s losses and gains and your total profit
This chart is based on stock prices at expiration Friday in November. Until then the spread’s value fluctuates between $0 and its maximum (the difference between strike prices) of $10.00
At any time until expiration, you can sell out of the spread but what you receive for the price may be influenced by implied volatility and time decay and that will change your profit or loss. If you hold the spread until expiration and your bullish lean proves true, your maximum profit on your $3500 investment is $6500.
You paid $3500 for the spread and received $10,000 at expiration with the stock at $60.00. That represents a $6500 profit which is a 186% return.
If you had invested $50,000 for 1000 shares of IJK and at expiration sold the stock for $60,000, your profit is $10,000 for a 20% return.
For many investors the reward/risk scenario of the spread is attractive because investors can limit the capital at risk and the time of risk/reward exposure. The spread also offers protection if your lean is bullish or bearish. Finally, the spread has the potential of a large percentage return on investment.

Options Trading Mastery: Behavior of the Time Spread

admin — Thu, 31 Dec 2009 05:25:55 +0000

Time spreads can be a profitable investment strategy if you understand the concept of time decay. A time spread is designed to take advantage of the fact that an options decay curve is non-linear, that is, an option’s value does not decay evenly over time. As an option gets closer to expiration, its rate of decay increases meaning the option loses value more quickly. That decay rate increases progressively until expiration.
An option’s decay rate begins to accelerate when the option is about 45 days out. It picks up steam at 30 days out and really comes under decay pressure at about 15 days out. This scenario is similar to a boulder rolling down from a hilltop. As it starts, it rolls slowly, then gains more speed, and momentum the further it gets down the hill until it achieves its maximum speed at the bottom. Option decay acts the same way – gathering speed and momentum as the option approaches expiration.
In time spreads, both options have the same strike price that remains constant. Each option’s value decays at different rates and over different lengths of time. The option, with one month until expiration, experiences value decay at a faster rate than the one with three months until expiration.
If you buy an option with three months to go and sell an option with the same strike but with one month to go, you have set up a spread between the two options values (prices). As time passes, your short option loses value more quickly than your long option that decays more slowly. The value of the spread widens and you profit from that spread’s expansion. This is the fundamental behavior of the time-spread.
Consider that you are long the 60-30 day time spread. That means you are long the 60-day option and short the 30-day option. We will assign a price of $3.00 to the 60-day option and $2.00 to the 30-day option. Since you pay for the one and receive payment for the other, the bottom line cost of what you put out for the spread is $1.00.
During the same 30-day period, it goes from $3.00 to $2.00. Remember, the spread’s bottom line cost was $1.00. The 30-day option (now expired) will be worth $0 while the 60-day option (now a 30-day option) will be worth $2.00. If you had invested in this spread, after 30 days decay you would be holding one option worth $2.00. The investment has provided a nice return!
This is an ideal situation. The stock price and volatility remain constant and you capture the decay. The time spread has worked just as it should. It does work that way sometimes, but nothing works as it should all the time. As we know, stock prices and volatility levels do not remain constant. They are always changing. In the time spread strategy, the investor must choose opportunities carefully. In addition to picking a stock that will be in a stagnant period, the investor should look for two other situations where the spread has profit possibilities: changes in volatility and to a lesser degree stock price movements.

Options Trading Mastery: Effects of Volatility on the Time Spread

admin — Wed, 30 Dec 2009 17:32:47 +0000

When purchasing a time spread, the investor should pay attention to not only the movement of the stock price, but also the movement of volatility. It plays a very large roll in the price of a time spread, which is an excellent way to take advantage of anticipated volatility movements in a hedged fashion.
Option Volatility
Since the time spread is composed of two options, the investor should understand the role of volatility in options as well as in time spreads. Let us start with option volatility.
We measure an option’s volatility component by a term called Vega. Vega, one of the components of the pricing model, measures how much an option’s price will change with a one-point (or tick) change in implied volatility. Based on present data, the pricing model assigns the Vega for each option at different strikes, different months and different prices of the stock.
Vega is always given in dollars per one tick volatility change. If an option is worth $1.00 at a 35 implied volatility and it has a .05 Vega, then the option will be worth $1.05 if implied volatility were to increase to 36 (up one tick) and $.95 if the implied volatility were to decrease to 34 (down one tick).
Keep these facts in mind as we continue to discuss Vega:
1. Vega measures how much an option price will change as volatility changes.
2. Vega increases as you look at future months and decreases as you approach expiration.
3. Vega is highest in the at-the-money options.
4. Vega is a strike-based number. It applies whether the strike is a call or a put.
5. Vega increases as volatility increases and decreases as volatility decreases.
It is important to note that an option’s volatility sensitivity increases with more time to expiration. Further out-month options have higher Vegas than the Vegas of the near term options. The further out you go over time, the higher the Vegas become. Although increasing, they do not progress in a linear manner. When you check the same strike price out over future months you will notice that Vega values increase as you move out over future months.
The at-the-money strike in any month will have the highest Vega. As you move away from the at-the-money strike in either direction, the Vega values decrease and continue to decrease the further away you get from the at-the-money strike. Remember, Vega (an option’s volatility component value) is highest in at-the-money, out-month options. Vega decreases the closer you get to expiration and the further away you move from the at-the-money strike.
The chart below shows Vega values for QCOM options. Observe the important elements. The stock price is constant at 68.5. Volatility is constant at 40. Time progresses from June to January. Finally, the strike price changes from 50 through 80. Notice the increasing pattern as you go out over time and how the value decreases as you move away from the at-the-money strike.
Chart 3- Vega
Stock Price 68.5 Vol. 40
Strike June July October January
50 0 .008 .064 .114
55 .004 .030 .102 .153
60 .023 .063 .135 .184
65 .053 .090 .157 .205
70 .056 .094 .165 .215
75 .032 .077 .154 .213
80 .011 .052 .142 .203
Another important fact about Vega is that it is a strike-based number. This means that the Vega number does not differentiate between put and call. Vega tells the volatility sensitivity of the strike regardless of whether you are looking at puts or calls. Therefore, the Vega number of a call and its corresponding put are identical.
The chart below shows the Vega values for calls and the corresponding puts. As you can see, these values match up in every instance.
Chart 6
Strike Price-Call Vega-Put Vega
June
60 .023 .023
65 .053 .053
70 .056 .056
July
60 .063 .063
65 .090 .090
70 .094 .094
October
60 .135 .135
65 .157 .157
70 .165 .165
January
60 .184 .184
65 .205 .205
70 .215 .215
Vega can also calculate how much a specific option’s price will change with a movement in implied volatility. You simply count how many volatility ticks implied volatility has moved. Multiply that number times the Vega and either add it (if volatility increased) to the option’s present value or subtract it (if volatility decreased) from the option’s present value to obtain the option’s new value under the new volatility assumption. The calculation works on individual options and can analyze the value of the time spread.
Apply Vega to Time Spreads
Now, let us apply the concepts of Vega to the Time Spread. When you apply the Vega concept to time spreads, you observe that as implied volatility increases, the value of the time spread increases. This is because the out-month option, with the higher Vega will increase more than the closer month option with the lower Vega. That widens or increases the spread.
The chart below shows a time spread and its reaction to increasing volatility. Each time that implied volatility increases, the value of the time spreads increase. This increase would naturally favor the buyer.
Chart 4
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 30 1.09 2.09
65.5 40 1.43 2.75
65.5 50 1.77 3.41
65.5 60 2.11 4.05
65.5 70 2.49 4.60
If an investor bought the time spread at low volatility and within a few weeks volatility had increased and pushed the spread price higher, the investor could sell the spread at a profit even before expiration.
Of course, the Vega can also demonstrate the opposing effect. As implied volatility decreases, the spread tightens or decreases in value. As volatility comes down, the out-month option with its higher Vega will lose value more quickly than will the nearer month option with its lower Vega. In the chart below, you will see how decreasing volatility affects the time spread’s value.
Chart 5
Stock Price $ Vol. June / July 65 Oct / July 65
65.5 70 2.49 4.60
65.5 60 2.11 4.05
65.5 50 1.77 3.41
65.5 40 1.43 2.75
65.5 30 1.09 2.09
Glance back to Charts 4 and 5. Take note that the stock price is constant. The changes in the price of the spreads are due to the change in volatility.
We discussed how to use Vega to calculate an option’s price when volatility changes. The same calculation method works for time spreads but the calculation is slightly more difficult.

Options Trading Lesson: Seller Risk & Reward

admin — Wed, 30 Dec 2009 05:31:53 +0000

The seller of a time spread buys the nearer month option and sells the outer-month option in a one-to-one ratio. To profit from the sale of the time spread, the seller must look for two things.
The first is a decrease in implied volatility. As volatility decreases, the out-month option (which the seller is short) loses money faster than the near month option (which the seller is long) because of the higher Vega in the out month option. This will cause the spread to contract or lose value and will be profitable for the time spread seller.
The second thing a seller should look for is a movement in stock. A time spread is at its widest, most expensive point when it is at-the-money. A movement away from the strike in either direction decreases the value of the spread. As long as the stock moves in either direction away from the strike, the seller’s position could be profitable if time decay does not outperform the stock movement.
Time, unfortunately, never works in favor of the time-spread seller. The nearer month option (which the seller is long) naturally decays at a faster rate than does the out-month option (which the seller is short). These differing decay rates cause the spread to expand and increase in value, which produces a loss for the time spread seller.
Increases in implied volatility are also detrimental to the potential profits of the time- spread seller. When implied volatility increases, the out month option (which the seller is short) increases in value faster than the near month option (which the seller is long). This is due to the out month option’s higher Vega which creates an expansion in the spread and increases its value resulting in a negative for the spread seller.
The seller, in theory, has an unlimited loss potential. The maximum loss potential is not so much determined by the stock price movement but by the movement in implied volatility. As the seller, you will be long the front month call and short the out-month call.
The out month call will be more sensitive to movements in implied volatility due to a higher Vega or volatility sensitivity component. If implied volatility increases, then the seller’s short, out month option will increase more in value than will the seller’s long, front month option. This will cause the spread to widen or increase in value – a negative for the seller.
The second risk is that the option the seller is long is going to expire approximately 30 days prior to the option the seller is short. If volatility does not decrease or the stock does not move away from the strike significantly before the seller’s long option expires, (s)he will be left short a naked or un-hedged option and a loss on the position.
If the seller can wait out the position, the lost extrinsic value of the short option is retainable. This option also has a limited life and must shed its extrinsic value, no matter how much, by its expiration. The problem facing the seller is that the position is no longer hedged and the seller now faces unlimited risk.
Once the long option expires leaving the seller short a now naked call, stock price movement in the wrong direction is a substantial risk and under the circumstances described above, a big problem.
While the seller can wait out an implied volatility movement that created an increase in extrinsic value, they will probably not be able to wait out a large, negative stock movement creating an increase in intrinsic value. In that case, the seller must take action to prevent substantial losses once the front month expires. Attention to the implied volatility in the farther out option when the nearer month option expires can save the seller from a large loss.

Options Trading Mastery: Construction of the Time Spread

admin — Tue, 29 Dec 2009 18:01:54 +0000

Time spreads, also known as calendar spreads, are an ideal way to take advantage of time decay and changes in implied volatility. Time spread strategy focuses on the movement of time and volatility more than on the movement of the stock. Therefore, it is perfect for when you anticipate stagnant or explosive periods in a stock.
Time spreads, like other spreads, have their own risks and rewards. The risks are very limited for the buyer, but substantial for the seller. The seller’s risk can be avoided or contained with due diligence at the expiration of the near month’s option. Several strategies can affect the seller’s risk. The advantage of the time spread strategy is that the investor can pursue a time decay or volatility position without the large capital outlay necessary for the purchase of the stock.
The construction of the time spread involves the purchase of one option and the sale of another in different months with both having the same strike. You can construct a time spread using either two calls or two puts. A long time spread is constructed by purchasing the out month option and selling the nearer month option. For example, you buy the September 45 call, sell the August 45 call or buy April 30 puts, and sell February 30 puts. You can construct a short time spread by selling the farther out month and buying the nearer month. For instance, sell July 50 calls and buy May 50 calls.
The important elements in the construction of the time spread are: using two call or put options on the same stock, using the same strike for both, choosing different months for each and using a one to one ratio. A one to one ratio means that you must purchase one option for every one you sell or sell one option for every one you buy. A time spread can utilize any two months as long as it has the same strike price and the trade is in a one to one ratio.
Most time spreads are executed at-the-money because at-the-money options have the greatest amount of extrinsic value. An option’s extrinsic value is what decays over time. This is the basis of the time spread’s strategy. Since the time spread is built to take advantage of time decay, it is better suited for at-the-money options. This does not mean that you cannot use the time spread with in-the-money or out-of-the-money options. In-the-money and out-of-the-money options have less extrinsic value than at-the-money options.
The rate of decay of an in-the-money or out-of-the-money option with one month until expiration is still greater than an in-the-money or out-of-the-money option of the same strike that has three months to go before expiration. This being said, the time spread can be constructed using any option regardless if it is in, out, or at-the-money.

Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Tue, 29 Dec 2009 05:36:48 +0000

Construction of a vertical spread occurs with the purchase and sale of a call (put) in the same stock and in the same month. The only difference between the two options is the strike price. For example, an investor would construct a vertical spread by purchasing the IBM June 55-call while selling the June IBM 60 call. This trade would be called the IBM June 55 – 60 call spread. Similarly, a purchase of the IBM July 45 put and sale of the IBM July 60 put would be called the IBM July 45 – 60 put spread.
The key to the constructing these vertical spreads is choosing options in the same stock and month, but different strikes and in a 1 to 1 ratio. That is, you must purchase one option for every one you sell or sell one option for every one you buy.
Value and the Vertical Spread
A vertical spread’s maximum value is the difference between the two strikes. For example, the maximum value of the June 55 60-call spread mentioned previously is $5.00. [60 - 55] = $5.
Spread- Difference in Strikes – Spread Maximum Value
August 35 – 40 call 5 $5.00
April 70 – 85 put 15 $15.00
Nov. 20 – 22.5 call 2.5 $2.50
Dec. 40 – 50 put 10 $10.00
Jan 60 – 80 call 20 $20.00
Using the June 55 – 60-call spread example, we will set the date to June expiration on Friday. On that day, all the June options will expire and the options will be worth parity, as all of the extrinsic value will have eroded away.
Where does the spread get its value? From its two components – the call (put) you buy or the call (put) you sell. Look at the spread’s value with a couple of different closing stock prices. If the stock closes at $55, then both the 55 strike and the 60 strike will be out of the money and worthless. The value of the spread will be zero since both options are worth $0. If the stock closes at $57.50, the June 55 calls will be worth $2.50. The June 60 calls will be out of the money and thus worthless, therefore the spread will be worth $2.50 (June 55 call $ 2.50 – June 60 call $0).
If the stock closes at $60.00, then the June 55 calls will be worth $5.00. Meanwhile, the June 60 calls will be worth $0. This means that the spread will be worth $5.00 (June 55 call $ 5.00 – June 60 call $0). This is the maximum value of the spread. Note that the maximum value is identical to the difference between the strikes.
As the stock goes higher, the June 60 call becomes in-the-money and gains intrinsic value. For every penny that the stock increases in value, the June 55 calls and June 60 calls gain value equally, keeping the $5.00 spread between the two strikes constant.
To see this, refer to the Table below.
Price- June 55 Call- June 60 Call- Spread
55 0 0 0
56 1 0 1
57 2 0 2
58 3 0 3
59 4 0 4
60 5 0 5
61 6 1 5
62 7 2 5
65 10 5 5
70 15 10 5
100 45 40 5
The difference between the strikes is the maximum value of all vertical spreads regardless of the distance between the two strikes. It does not matter whether the spread is $5.00 wide, $10.00 wide, $20.00 wide, or even $50.00 wide. Its maximum value is the difference between the two strikes. Further, the vertical spread’s maximum value (the difference between the two strikes) holds true for vertical put spreads as well as vertical call spreads. Look at our other example, the July 45 – 60 put spread.
Again we set time forward to Friday, July expiration. We set the stock closing price at $60.00. At $60.00, both the July 45 puts and the July 60 puts will be out of the money and thus worthless. With the July 45 puts and July 60 puts worthless, the spread is also worthless (July 60 put $0 – July 45 put $0). If the stock finishes at $52.50, then the July 60 puts will be worth $7.50 while the July 45 puts will still be worthless. In this scenario, the July 45 – 60 put spread will be worth $7.50 (July 60 puts $7.50 – July 45 puts $0). If the stock finishes at $45.00, then the July 60 puts will be worth $15.00 while the July 45 puts will be worth $0.
At this level, the spread is worth $15.00 (July 60 puts $15.00 – July 45 puts $0). This is the maximum value of the spread. As you can see, it is identical to the $15.00 difference between the strikes.
As the stock lowers, the July 45 puts become in the money and gain intrinsic value. For every penny that the stock decreases in value, the July 60 puts and the July 45 puts will gain value equally, keeping the $15.00 spread between the two strikes constant. To see this, refer to the table below.
Price- June 60 Put- July 45 Put- Spread
65 0 0 0
62 0 0 0
60 0 0 0
57 3 0 3
55 5 0 5
50 10 0 10
47 13 0 13
45 15 0 15
42 17 2 15
40 20 5 15
As stated, the maximum value of a vertical spread is the difference between the two strikes while the minimum value of the spread is, of course, $0. This means that in this strategy, both the buyer and the seller have a limited, fixed maximum loss.
The buyer can only lose what he spent. Therefore, if the buyer spent $2.20 to purchase the August 35 – 40-call spread, the most he can lose is the $2.20 he spent.
For the seller, the maximum loss is the difference between the maximum value of the spread (difference between the strikes) and the amount of money received for the sale of the spread. For example, if you were to sell the August 35 – 40-call spread for $2.20 then your maximum loss will be $2.80. Remember, the maximum value of the spread is the difference between the 2 strikes or $5.00 (40 – 35).
The difference between the maximum value of the spread ($5.00) and the amount the seller received for the sale ($2.20) leaves a $2.80 maximum loss.
Below, the chart shows the potential amount of money, both profit and loss, that can be made or lost by both the buyer and the seller.
Closing – Aug 35-40 Call Spread – Aug 35-40 Call Closing Price - Buyer P & L – Seller P & L
30 2.20 0 -2.20 +2.20
32 2.20 0 -2.20 +2.20
34 2.20 0 -2.20 +2.20
35 2.20 0 -2.20 +2.20
36 2.20 $1.00 -1.20 +1.20
37 2.20 $2.00 - .20 + .20
38 2.20 $3.00 + .80 - .80
39 2.20 $4.00 +1.80 -1.80
40 2.20 $5.00 +2.80 -2.80
42 2.20 $5.00 +2.80 -2.80
44 2.20 $5.00 +2.80 -2.80
46 2.20 $5.00 +2.80 -2.80
48 2.20 $5.00 +2.80 -2.80
50 2.20 $5.00 +2.80 -2.80
It is important to understand and remember that vertical spreads have both a limited profit and a limited loss scenario for both the buyer and the seller.

Options Trading Mastery: Understanding Spread Prices

admin — Mon, 28 Dec 2009 17:30:43 +0000

During the life of a vertical call spread, the spread will trade between its minimum and maximum values (between 0 and the difference between the two strikes). In the case of a vertical call spread, the spread will trade closer to zero when the stock trades closer to or lower than the lower strike price. The spread will trade closer to maximum value when the stock trades closer to or higher than the higher strike price.
Starting from a stock price of 37.5, a price located directly between the two strikes, (using our example of the August 35 – 40 call spread) we can see the approximate value of the spread is roughly $2.5 dollars. This is because the August 35 calls and the August 40 calls are equidistant from the current stock price of $37.50. Being equidistant from the stock, both the August 35 and 40 calls will have almost the same amount of extrinsic value in them. Thus, in the spread, the extrinsic values of the two options cancel themselves out since you are long one call and short the other. This would leave each option value consisting of only intrinsic value. With the stock at $37.50 the value of the August 35 – 40 call spread will be $2.50. The August 35 calls will have $2.50 in intrinsic value while the August 40 calls will have $0 in intrinsic value. The difference gives you a spread with a value of $2.50.
A general rule of thumb is: if the stock price is located evenly between the two strike prices, the vertical spread should be worth roughly half of the value of the distance between the two strikes. This will be true for vertical put spreads as well as call spreads. From this rule, we can roughly estimate the vertical spread’s price per different stock prices.
For vertical call spreads, if the spread is worth roughly half of the difference between the two strikes with the stock price directly between the two strikes, then as the stock falls to lower strike and beyond, the spreads value will decrease and move closer to $0. Time left until expiration and volatility will dictate how close and how quickly it will approach $0. On the other side, as the stock climbs toward and above the upper strike, the spreads value will increase toward its maximum value described by the difference between the two strikes.
For vertical put spreads, as the stock price decreases toward the lower strike price, the spread will increase in value and approach its maximum value as defined by the difference between the two strikes. As the stock price increases toward the higher strike, the spread will decrease in value and will approach $0. Again, time until expiration and volatility will determine how quickly and how close the spread will approach $0.

Options Trading: Intrinsic Value and the Vertical Spread

admin — Mon, 28 Dec 2009 05:42:44 +0000

An investor must always keep in mind that vertical spreads have an intrinsic value. This means it is possible to consider them ‘in the money.’ If a vertical spread has an intrinsic value, it can also have an extrinsic value. Unlike maximum intrinsic values that equal the difference between the strikes at expiration, maximum extrinsic value deviates from spread to spread based on several factors.
During a vertical spread’s life, its price will fluctuate between zero and the value of the difference between the two strikes. An investor can determine the price of the spread, at any given time, by the location of the stock and the time until expiration.
At expiration, what remains for the two options is the intrinsic value of each. Therefore, the value of the spread is the difference between each option’s intrinsic values at expiration.
Because vertical spreads have an intrinsic value, the term ‘moneyness’ applies to them. Moneyness refers to whether or not and by how much an option, or a vertical spread, may be in the money or out of the money. This is a term used mostly by floor traders, but is still worth noting here.
Vertical Call Spread and Vertical Put Spread Value
Spreads with intrinsic value are considered in the money. How can you identify the value of a vertical call spread or a vertical put spread? Compare the stock price to the strike prices.
Look at any vertical call spread. If the stock price is above the lower strike of the spread, the spread is in the money. In the Feb. 50 – 55-call spread, if the stock is trading at $52.00, then the spread would be in the money by $2. This is because if the spread expired today, the Feb. 50 calls would finish $2.00 in the money. The Feb. 55 calls would finish worthless because they are out of the money. The spread, however, would be in the money with a value of $2.00.
The rule is similar for determining whether or not a spread is out of the money. If the stock price is lower than the lower strike of the spread, the spread is out of the money. Again, looking at the Feb. 50 – 55 call spread, if the spread expired today and the stock price closed at $48.00, (lower than the lower strike) then the spread would be out of the money, thus the spread will be out of the money. If the stock is trading at the same price as the lower strike price, the spread is considered at the money.
For vertical put spreads, a spread is determined to be in the money if the stock price is lower than the higher of the two strikes of the spread. For example, look at the Sept. 40 – 45 put spread. If the stock closes at $42.00 on expiration day, the Feb. 45 put would end up in the money and worth $3.00. The Feb 40 puts would be out of the money creating a $3.00 intrinsic value for the spread. Since the spread has an intrinsic value, it is in the money.
A vertical put spread is out of the money if the stock price is higher than the higher strike of the spread. So, going back to our Sept. 40 – 45 put spread example, if the stock was to close at a price of $46.00 (higher than the higher strike) then both the Sept. 40 and 45 put will expire worthless. Thus the spread will be worthless and out of the money.
A vertical put spread is considered at-the-money when the stock price is equal to the higher strike price.