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Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Thu, 22 Sep 2011 15:58:51 +0000

Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Fri, 19 Aug 2011 11:30:01 +0000

Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Mon, 15 Aug 2011 20:10:45 +0000

Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Sun, 09 Jan 2011 23:27:25 +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: Construction & Value of a Vertical Spread

admin — Thu, 06 Jan 2011 08:16:07 +0000

Options Trading Mastery: Construction & Value of a Vertical Spread

admin — Mon, 03 Jan 2011 07:39:53 +0000

Options Trading Mastery: Factors that Affect Straddle Prices

admin — Fri, 10 Dec 2010 04:00:25 +0000

Since the Straddle’s profit potential depends on its price from purchase time to expiration, the investor should be aware of the factors that affect the Straddle;s price. Several factors affect a Straddle’s price. The first is, of course, stock price. The stock’s price dictates the value of both components of the Straddle – the call and the put – affecting the Straddle price as a whole. As the stock price moves, the prices of the call and the put will fluctuate via the current Deltas of the options and thereby affect the price of the Straddle.
As the stock moves higher, the price of the call will increase while the price of the put decreases. They do not move linearly, meaning that as the stock continues higher, the call’s value increases progressively more while the put’s value decreases progressively less. This non-linear effect is because of the option’s changing Delta.
The call Delta increases as the stock goes up while the put Delta decreases. This opposing effect continues until the call gains value dollar for dollar with the stock (once its Delta reaches 100) indefinitely. At the same time, the put value-loss stops because the put now has no value (as put Delta approaches 0).
The opposite is true if the stock trades down. The call will lose value progressively slower until it reaches $0. Meanwhile, the put will gain value at an increasing rate until the Delta becomes 100. Then the put will gain dollar for dollar with the stock indefinitely. The chart below illustrates the effect of stock movement on the dollar value and Delta value of the Straddle.
Again, we will use the July 65 Straddle as an example. The Straddle will be worth $4.10 ($2.10 for the call, $2.00 for the put).
Stock/ Call/ Call Delta/ Put/ Put Delta/ Straddle
57.50 .42 15 7.81 -86 8.23
59.50 .78 24 6.16 -77 6.94
61.50 1.35 34 4.17 -67 6.06
63.50 2.11 45 3.46 -56 5.57
65.50 3.13 56 2.47 -44 5.60
67.50 4.35 66 1.69 -34 6.04
69.50 5.77 75 1.11 -25 6.88
71.50 7.37 83 .71 -17 8.08
73.00 9.09 83 .43 .12 9.52
A second factor that affects the pricing of a Straddle is implied volatility. As implied volatility increases, the value of the Straddle increases. The price of both calls and puts increase as implied volatility increases. A Straddle will feel a double effect when volatility increases because the strategy employs two options working together and not against each other.
When a strategy uses two options working against each other, the effect of implied volatility on the strategy is the difference of its effect on each option. This is different from a Straddle where the two options are working together. This combines the effect of implied volatility on each option.
Implied volatility movement affects an individual option to an exact dollar amount as indicated by the option’s volatility sensitivity component or Vega. An option with a $.05 Vega will increase five cents in value for every tick that implied volatility increases. It will decrease in value five cents for every tick that implied volatility decreases.
A call and its corresponding put will have the same Vega. That is, if the July 65 call has a .10 Vega, then the July 65 put will also have a .10 Vega. Remember, Vega is calculated by the strike price and does not differentiate put or call. Now that we have confirmed this concept, we can use it to calculate how much our Straddle price will change with a movement in implied volatility.
The Straddle combines a call and its corresponding put doubling the Vega effect. This means that the Vega of a Straddle is the addition of the Vega of the call and the Vega of the put. Since the put and call Vega are the same, we simply times the Vega of the strike by two.
Look back at our example. If the July 65 call has a .10 Vega, then the July 65 put must also have a .10 Vega and thus the July 65 Straddle will have a .20 Vega. This means that for every tick that implied volatility increases, the July 65 Straddle will increase $.20 in value. Conversely, for every tick that volatility decreases, the July 65 Straddle will decrease in value. The chart below shows how the Straddle-value changes at different implied volatility levels.
Price/ Vol.Level Call Put Straddle Vega
65.50 30 3.13 2.47 5.60 .174
65.50 40 4.05 3.39 7.44 .180
65.50 50 4.96 4.31 9.27 .182
65.50 60 5.88 5.23 11.11 .184
65.50 70 6.80 6.15 12.95 .184
When you study the chart, you can see that as implied volatility increases or decreases, the value of the Straddle increases or decreases by the amount of the Straddle’s Vega multiplied by the amount of tick change in implied volatility.
Finally, time is another major factor affecting the price of a Straddle. Time takes a toll on all options. Its effect is even more pronounced on the Straddle which that combines two options for the same period. A Straddle will see twice the rate of decay that a single option will. From previous discussions, we should be familiar with the option decay chart and its non-linear curve. As time goes by, the Straddle will decay, day after day, at an ever-increasing rate until expiration Friday at 4:00 p.m.
The implication to the buyer and seller is obvious. The passage of time decreases the value of the Straddle and thus always favors the seller. Time works against the buyer. The buyer has until expiration to get either a large stock or implied volatility movement to offset the price paid for the Straddle.

Options Trading Lesson: Seller Risk & Reward

admin — Sat, 07 Nov 2009 17:33:47 +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: Option Strangles

admin — Tue, 03 Nov 2009 16:56:46 +0000

The Strangle is another option strategy that features the use of options in unison with each other. The Strangle is philosophically identical to its ‘cousin’ the Straddle. However, whereas the Straddle has a single strike as its focal point, the Strangle has its focal point spread out over two strikes.
The effect of this as compared to the Straddle is that the Strangle will produce wider break-even points and lower prices. The widening of the break-even points changes the risk/reward scenarios for both the buyer and the seller of the Strangle as opposed to the Straddle.
The benefit to the buyer of the Strangle is that it will cost less than a Straddle (thus less risk) but, like all risk/reward scenarios, less risk equals less reward. The buyer’s trade-off for lower cost and less risk is that the stock will have to move significantly more than if the buyer had purchased a Straddle.
The benefit to the seller of the Strangle is that it offers a larger margin of error in terms of the anticipated stock movement. The wider range of the break-even prices allows the stock to have more movement while still allowing the seller to profit. The seller’s trade-off for this luxury is price. The seller will not bring in as much premium from the sale of a Strangle as opposed to the sale of a Straddle.
With that said, let’s look at the Strangle. The Strangle, like the Straddle, consists of two options. In the Strangle, however, the two options are not at-the-money options of the same strike (Straddle), but out-of-the-money options (both a call and a put) of different strikes.
The Strangle features one position (either long or short) and two options: an out-of-the-money call and an out-of-the-money put.
When you put together a Strangle the construction should be as follows:
- Different options (out-of-the-money call & an out-of-the-money put)
- Same stock
- Same expiration
- One to one ratio
Strangle positions are referred to as ‘long Strangle’ or ’short Strangle’ depending on whether you purchase the call and the put (long) or sell the call and the put (short).
For example, with the stock trading at $57.50, you would construct the long Strangle by purchasing both the July 60 call and the July 55 put. You would construct the short Strangle by selling both the July 60 call and the July 55 put.
It is important to note that the Strangle is a one to one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one put to properly construct a Strangle.

Options Mastery Lesson: Straddles

admin — Thu, 29 Oct 2009 07:34:10 +0000

In our previous reports, we discussed option strategies that feature the use of options in combination with stock such as the buy-write and the use of options against each other in the form of spreads. We will focus on the Straddle, which uses options in unison with each other.
Unlike a spread that features a long option versus a short option, the Straddle features one position (either long or short) and two options – a call and its corresponding put. A Straddle is the strategy composed of a long (or short) call and a long (or short) put where both options have the identical strike price and expiration month.
When putting together a Straddle, the construction should be as follows:
-Different options (call and its corresponding put)
-Same stock
-Same strike
-Same expiration
-One-to-one ratio
Straddle positions are referred to as ‘long Straddle’ or ’short Straddle’ depending on whether you purchase the call and its corresponding put (long) or sell the call and its corresponding put (short). For example, we will construct the long Straddle by purchasing both the July 60 call and the July 60 put. We will construct the short Straddle by selling both the July 60 call and the July 60 put. It is important to note that the Straddle is a one-to-one ratio strategy. For every call that you buy (or sell), you must purchase (or sell) exactly one corresponding put.
Straddle Scenarios
The Straddle relies on movements in stock price or in implied volatility to establish profit opportunities. The Straddle buyer looks for the stock to move aggressively in either direction or for the anticipated perception of possible aggressive moves that will bring about an increase in implied volatility.
Sellers of the Straddle hope for the opposite scenario. A lack of stock movement or a perceived lack of movement, causing implied volatility to decrease, will create profitable scenario.
Straddle Mechanics
Let’s look at how a Straddle works. In our illustration, we see the July 65 Straddle. We can either buy or sell the Straddle. If we purchase both the July 65 call and the July 65 put simultaneously in a one-to-one ratio we have a long Straddle. To construct a short Straddle we would sell both the July 65 call and July 65 put simultaneously in a one-to-one ratio.
Continuing with our illustration, we will set the price for each of the options. With our imaginary stock trading at $65.50, the July 65 call trades at $3.13 and the July 65 put trades at $2.47. The combination of these two prices accounts for the $5.60 cost of the Straddle. Fast forward to expiration and observe what happens to the value of the Straddle at different stock prices.
Price Call Put Straddle P & L
50 0.00 15.00 15.00 9.40
55 0.00 10.00 10.00 4.40
60 0.00 5.00 5.00 -.60
65 0.00 0.00 0.00 -5.60
70 5.00 0.00 5.00 -.60
75 10.00 0.00 10.00 4.40
80 15.00 0.00 15.00 9.40
As you can see, the Straddle’s value increases the further the stock moves away from the strike. The closer the stock is to the strike, the lower the value of the Straddle at expiration. The chart clearly shows that the more the stock moves away from the strike, the higher the Straddle’s value becomes. Conversely, the closer the stock finishes to the strike, the lower the value of the Straddle. Owners of Straddles want and need movement while sellers of Straddles want and need stagnation.
How does this example influence your investment strategy? If you feel that a stock is likely to move aggressively in either direction or if you feel that implied volatility is likely to increase, possibly due to impending news (such as earnings, FDA approval, etc.), look into the purchase of a Straddle. If you feel a stock is likely to enter a stagnant phase, or if you feel that implied volatility is likely to decrease, the sale of a Straddle can be a very profitable trade for you.