November 5, 2008
Options Trading Mastery: Vertical Spread Test Scenario
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.
By: Ron Ianieri
About the Author:
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.
By: Ron Ianieri
About the Author:
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227
Filed under Investing by Administrator
October 30, 2008
Options Trading Mastery: Getting Out or Rolling the Position
The selection and management of a vertical spread are only two-thirds of the game. Closing out, rolling or morphing the position has to be analyzed and executed with the same due diligence as was used in the selection and management processes.
Looking at the closing out of a vertical call spread, we find there are three possible outcomes that must be addressed. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In this scenario, in order to close out the spread, one would just let it expire. Both options finish out of the money so no residual position will be left over.
If the spread finishes fully in the money, (at maximum value) that is with both options in-the-money, then both options will be exercised. You will exercise your long call and your short call will be assigned. They will cancel each other out and you will be left with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
The difficult scenario is when the stock closes in between the two strikes of the spread. This scenario, the closing of the stock between the two strikes creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money.
When both options expire in-the-money, they are both exercised-one creating a long stock option, the other creating a short position thus canceling each other out. This is not the case here. Here, one option, the one that is in-the-money will leave a residual stock position and since the other option is out-of-the-money, it will not be able to be used to offset the residual stock position created by the expiring in-the-money option.
There are two actions that could be taken. Choice number one involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. Giving up a portion of the profits may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk (albeit short-lived because you are doing this late on expiration day of the expiring month) that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. If that happens, you will now be naked the residual stock position. Of course, if there is still time, you could always trade out of the option then but that is very risky. However, if the stock is at a relatively safe distance from the out-of-the-money you may want to just close out the in-the-money option and let the out-of-the money option expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this is being done at the very end of the day on expiration day. These options only have minutes of life left. So, knowing this, the risk is somewhat mitigated, but still there none the less.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, you would be best advised to trade out of the spread entirely.
Again, as stated before, if the stock closes either with the spread fully in-the-money, or fully out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position. We discussed above how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
Then, if you have 10 July 50 calls and you exercise them you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.
By: Ron Ianieri
About the Author:
Looking at the closing out of a vertical call spread, we find there are three possible outcomes that must be addressed. The spread can finish out-of-the-money and valueless. For a call spread, this scenario occurs when the stock closes at or below the lower strike of the spread. In this scenario, in order to close out the spread, one would just let it expire. Both options finish out of the money so no residual position will be left over.
If the spread finishes fully in the money, (at maximum value) that is with both options in-the-money, then both options will be exercised. You will exercise your long call and your short call will be assigned. They will cancel each other out and you will be left with no residual position. This scenario occurs when the stock price closes lower than the lower strike call involved in the spread.
The difficult scenario is when the stock closes in between the two strikes of the spread. This scenario, the closing of the stock between the two strikes creates a situation where one strike winds up being in-the-money while the other ends up out-of-the-money.
When both options expire in-the-money, they are both exercised-one creating a long stock option, the other creating a short position thus canceling each other out. This is not the case here. Here, one option, the one that is in-the-money will leave a residual stock position and since the other option is out-of-the-money, it will not be able to be used to offset the residual stock position created by the expiring in-the-money option.
There are two actions that could be taken. Choice number one involves trading out of the spread on expiration Friday just before the close. Because of the bid/ask spread of the two options, you will probably have to give away some of your profits in order to close out the position. Giving up a portion of the profits may be the best thing to do in order to avoid naked, unlimited risk.
If you only trade out of the in-the-money option, you run the risk (albeit short-lived because you are doing this late on expiration day of the expiring month) that the stock moves adversely and the out-of-the-money option suddenly becomes in-the-money. If that happens, you will now be naked the residual stock position. Of course, if there is still time, you could always trade out of the option then but that is very risky. However, if the stock is at a relatively safe distance from the out-of-the-money you may want to just close out the in-the-money option and let the out-of-the money option expire worthless.
The two factors that must be considered are: the combination of the distance of the strike from the stock price in relation to the short amount of time for the stock to get there, and the amount of money saved by not buying back the out-of-the-money option. Remember, this is being done at the very end of the day on expiration day. These options only have minutes of life left. So, knowing this, the risk is somewhat mitigated, but still there none the less.
The catch is the proximity of the stock to the out-of-the-money option. If the stock is close to the out-of-the-money option, you would be best advised to trade out of the spread entirely.
Again, as stated before, if the stock closes either with the spread fully in-the-money, or fully out-of-the-money, the position will adjust itself through the exercise process leaving no residual position. If the stock price finishes between the two strikes, there will be a residual position. We discussed above how to trade out of this position. Your second choice is not to trade out and allow yourself to go through the expiration process. You must remember that if you are going to accept a residual stock position, you must be able to afford it.
Then, if you have 10 July 50 calls and you exercise them you will be receiving 1000 shares of stock at $50.00 per share. Thus, you must have $50,000.00 of cash and/or margin in your account to receive the stock. If you do not have enough cash and/or margin to accept delivery of the stock, then you must trade out of the position before it expires.
By: Ron Ianieri
About the Author:
Ron Ianieri is currently Chief Options Strategist at The Options University, an educational company that teaches investors how to make consistent profits using options while limiting risk. For more information please contact The Options University at http://www.optionsuniversity.com or 866-561-8227
Filed under Investing by Administrator