Verticals – Under and Out

Online Training Academy Article of the Week

by Russ Allen, Online Trading Academy Instructor

This week we’ll continue following our GLD vertical spread example, and show an illustration of how to plan and execute an exit from a trade that doesn’t do what we wanted.

Our example is the 156/160 March Call Spread on the ETF called GLD that we discussed at the end of last week’s article (you can find that here). With GLD at $161.16, We bought the 156 March calls at $5.80, and sold the March 160 calls at $2.80, for a net debit of $3.00. Both of these calls were in the money. We wanted them both to stay in the money. As of today (February 13, 2013), there are 30 days to go on this spread.

Our maximum possible loss (per share) on this spread is $3.00, the debit incurred to enter the trade. This maximum loss would occur if the price of GLD were below the $156 strike price of our long options at expiration.  In that case, both the 156 and the 160 calls would expire worthless, and we’d just write off the $3.00.

Our maximum gain on this trade is $1.00 per share. This would occur if GLD is at any price above the $160 strike of our short calls at expiration. In that case, our right to buy at $156 and our obligation to sell at $160 ($4.00 higher) would result in a $4.00 net value for the spread.  Since we bought it for $3.00, our profit would be $1.00.

Even though this $1.00 maximum profit is much smaller than our $3.00 maximum loss, making the maximum profit was far more likely. GLD didn’t have to go up for us to make that $1.00 – all it had to do was not drop by any more than $1.16. And short of making our maximum profit, all that GLD had to do for us to make some profit was not to drop below our break-even point of $159. Referring to the Deltas of the options, there was roughly an 84% chance that GLD would be above the $159 breakeven at expiration.

Below is a P/L diagram for this spread.

Click to enlarge

As always on these graphs, the straight green line is the expiration P/L line. It shows what the profit or loss will be at any price of GLD, at expiration, at the close of business on March 16. This line is immovable. It absolutely defines what the spread will be worth at any price of GLD, regardless of volatility, interest rates, or anything else.

On this graph, there are three additional plots. These show the P/L curve as it appears today, and as it will appear at selected dates in the future (if Implied Volatility doesn’t change). These are different from the expiration P/L line, because the expiration P/L line explicitly defines a situation where there is no time value in any option.  Up until the one instant where that is literally true, the moment of expiration, some options do have time value.  As far as the time value in an option is concerned, where there’s life, there’s hope. That makes the relationship between their prices different. We can measure and predict those differences – the multicolored lines show those predictions.

The blue curve is today’s P/L curve. As the price of GLD rises and falls during the day today, we can think of the open profit amount as a ball rolling up and down the blue line, so that it always aligns vertically with the current price of GLD on the horizontal axis. As GLD’s price rises, the profit amount rolls up the blue line. If GLD drops in price, the ball rolls down the blue line.

Tomorrow, the shape of the P/L curve will be different. With every day that passes, there is less time for price to move before the options expire. With less time, the amount of probable price movement is less. That’s why every option loses time value every day, as long as it has any time value left to lose.

The red and yellow lines illustrate this. The red line shows what the P/L curve will be 16 days from now, when there are 14 days before expiration. The yellow line shows what it will be 10 days later, when there are only 4 days to go. On expiration day on March 16, with no time left, the “today” line will be the same as the expiration P/L line.

With each day that passes until then, each day’s current day’s P/L line will move closer to its inevitable fate, which is to merge with the expiration P/L line. As it does so, it pivots around a point that is roughly halfway between the strikes. In this case, halfway between the 156 and the 160 strikes is 158, and the pivot point is near there. Above an asset price of 158, all of the current and future P/L curves lie above the expiration P/L line. At lower prices, all of the P/L curves lie below the expiration P/L line.

Today GLD closed at almost exactly $159.00. This happens to be the break-even price on the expiration P/L line.  If held until expiration, at a GLD price of $159.00, this spread will break even.  Our long $156 calls will be worth (stock price – strike price) = ($159.00 – $156.00) = $3.00, which is the original cost of the spread. The short $160 calls will be worthless. You can see that the green expiration P/L line crosses the zero P/L line at a GLD price of $159 (a little to the right of the $158.60 label on the zero P/L line).

But today (2/13), the open profit on the trade is not yet at breakeven – it’s showing a loss of about $.64. The current day P/L line is below the zero P/L line by about $.64. That means to get back to zero P/L, we’d have to wait until expiration.

This is not nearly as good a result as we reasonably expected when we set up this trade, when GLD was over $2.00 higher, at a price of $161.16. At that time, our expectation was that GLD would hold steady or rise. As long as it did not drop below our $160 strike, we would make our maximum profit of $1.00. And as long as it did not drop and stay below our breakeven of $159.00, we would make some profit on the trade. At that time the Deltas told us we had about an 84% chance of that. But things have changed. Probabilities are just that – not certainties.

This illustrates why it’s important to have a plan for managing every trade when you enter the trade. When we put on this trade, we knew our maximum profit, maximum loss, the underlying prices required for each, and our breakeven price. Our plan to manage the trade has to include an exit strategy for taking profits, and a plan for taking losses. On some trades, the plan is as simple as waiting for expiration and either collecting the money or taking the loss. This is not one of those, because the potential loss is much larger than the potential profit. Even so, it was a risk worth taking because the probability of profit was much greater than the probability of any loss.

As traders trained in technical analysis, our exit plan had to include an underlying price level at which we would conclude that our bullish outlook had been wrong, where we would exit the trade before further losses were incurred. This price should be a Demand Zone that we believe will support the price. In fact, there is a demand zone right above $159. Our plan should be, “If that demand fails, we bails.”

Some option traders select their exit prices differently, based on risk/reward on the option trade itself – one method of exiting is to get out when price passes your breakeven point – as it has now.

Using either method, one thing is true – If we stay in this trade, we would now be in the position of sweating out 30 days of time decay, hoping for no further downward price movement, just to break even. Meanwhile, if GLD drops too much further, we could lose our whole $3.00 debit, which is an additional $2.36 loss on top of the $.64 loss we have now. Given where price is now, whether it will move up or down from here is a toss-up, and those are not the kind of odds we play.

It’s time to follow our plan and exit this trade: Buy back the short GLD March 160s and sell the long GLD March 156s, for a net cash inflow of about $2.36. We took a $64 hit, but we now have our remaining $236 to deploy on better opportunities.

So we covered a few different points today:

1. It’s crucial to be able to analyze an option P/L diagram. You must be able to visualize what happens to your profit as price changes; and how that picture changes as time passes.
2. As time passes, the P/L curve on the graph continuously moves toward the expiration P/L line.
3. The ability to visualize these changes on the graph helps you to formulate the plan that you must have – where to exit when the trade goes right, and where to exit when it goes wrong.
4. When the time comes according to your plan – pull the trigger.