Vertical Spreads – Part 2

February 15th, 2013
in contributors, syndication

Online Trading Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

In last week’s article, which you can read here, I began to talk about Vertical Spreads. These are positions involving one long option and one short option, both of the same type (Puts or Calls) and expiration date, but with different strike prices. Today I want to continue our exploration of these spreads.

Vertical Spreads (or just “verticals”) are very versatile. By selecting option strike prices at different distances from the current underlying price, we can construct vertical spreads for different purposes. It is our selection of strike prices that determines whether our spread is designed to profit from price movement of the underlying; or from a change in Implied Volatility (IV); or just from time decay.

Follow up:

Our first example from last week was a simple one, designed to profit from an increase in price. We bought GLD March 1 Weekly 160 calls at $2.80 because we were bullish on GLD. We turned this long call position into a Debit Vertical Call Spread by selling GLD March 1 Weekly 164 calls at $1.00. Our net cost was (Cost of long options – proceeds from short options) = ($2.80 – $1.00) = $1.80.

This particular spread is a vertical, it’s bullish, it’s done with all calls, and it requires paying money (incurring a debit) to enter. It can be called by various names such as a Bullish Vertical Call Spread, often shortened to Bull Call Spread or just Bull Call; or Debit Call Spread. All are accurate descriptions.

Below is the Payoff Diagram for this position.

Click to enlarge

Let’s consider just the straight green lines. The green plot shows the profit or loss of the position at any given GLD price at expiration.

The shape of the graph shows us instantly that this is a bullish trade, with limited risk, and limited profit. We know it’s bullish because there is an upward-sloping section (higher underlying price = higher profit).  We know it has limited risk because at its lowest point the green line goes flat – it does not continue down to infinitely large negative numbers.  Likewise we know it has limited profit because at its highest point the green line goes flat again – it does not continue up to infinitely large positive numbers.

The points at which the P/L line goes flat are at the strike price of the long call ($160) and at the strike price of the short call ($164). Payoff graphs always have an inflection point (they change direction) at each strike price. It’s easy to see why in this case.

At expiration, if GLD is at or below $160, our $160 calls are worthless. We’ve lost the $2.80 we paid for them. If the 160s are worthless, then the 164s that we sold for $1.00 also must be worthless. Therefore we will have made $1.00 on them. So our net loss is our original net debit of ($2.80 – $1.00) * 100, or $180. This will be the result no matter how low the price of GLD is. Once GLD is low enough to make both calls worthless, it doesn’t matter how much lower it goes.

On the other hand, if at expiration GLD is at any price above $164, then both calls will be in the money, and therefore both will have intrinsic value. Each option will be worth its intrinsic value, and their intrinsic values will be $4.00 apart – the difference between the 160 and 164 strikes. Above 164, the spread will have reached its maximum value of $4.00, and we will be able to sell it for that, regardless of the actual price of GLD. Subtracting the debit of $1.80 we paid to enter the trade, we make a profit equal to (spread value at expiration – cost of spread) = ($4.00 – $1.80) = $2.20 per share, or $220 per contract.

Since we lose money below a GLD price of $160 and make money above $164, the break-even price must be between the two – above $160 but below $164. It follows that at breakeven the 164 calls will be OTM, and therefore worthless. The long 160 calls will have the only value. So those 160 calls would have to be worth exactly the original net cost of the spread, which here is $1.80. The 160 calls would be worth $1.80 if GLD was at $160 + $1.80 = $161.80. The breakeven for a Bull Call Spread is always the long strike price plus the debit.

I said at the beginning that different strike selections would change the characteristics of the spread.  In this case, with GLD at 161.16, the 160 call we bought was in the money (ITM), and the 164 call we sold was out of the money (OTM). Let’s see what happens when we change those strikes.

Let’s slide those strikes down so that both are ITM to start with. Instead 160/164, let’s look at the 156/160 spread. At the close on January 31, we could have bought the 156s at $5.80, and sold the 160s at $2.80, for a net debit of  ($5.80 – $2.80) = $3.00. This spread would be markedly different from the 160/164 spread, in the following ways:

  • The spread would have its maximum value of $4.00 at expiration as long as both the 156s and the 160s were in the money; that is, at any GLD price above $160, therefore
  • The price of GLD does not have to rise for this spread to make its maximum profit. It only has to not fall below $160. This is no longer a directional spread – it’s an income-generator with only a slight bullish bias.
  • At its $4.00 maximum value, our profit on the spread would be (Spread value – cost of spread) = ($4.00 – $3.00) = $1.00. This is smaller than the max profit on the 160/164 spread, but it occurs at a much lower price.
  • Our maximum loss on this spread is larger, since our debit is $3.00. For this to happen, though, GLD would have to fall and stay below the 156 strike.
  • Our breakeven price here is (long option strike price + net debit) = ($156 + $3.00) = $159.00. For us to lose money, the price of GLD would have to fall and stay below $159.00.
  • Our probability of making a profit is the same as the probability of GLD ending up above our $159 break-even price at expiration. We can roughly approximate that by looking at the Delta of the 159 calls, which was  84. So this position would have about an 84% chance of making some profit.

So to wrap up for today, we’ve shown that a vertical spread can be more than one thing. With one set of strike prices, we can create a bullish trade with a high payoff if we’re right. With another set of strikes, we have a price-neutral trade with a somewhat lower payoff, and all we have to do is not be too far wrong. There are other possibilities, which we’ll get into next time.

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