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Lessons from the Pros - Options

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Vertical Spreads: Part III

Tue, Nov 3 2009, 11:46 GMT
by Josip Causic

Online Trading Academy

The goal of this article is to walk the readers step-by-step through my thinking process when placing a vertical debit call spread trade. In the classroom setting, I have the luxury of time so I can get deeper into the details about each strategy; however, in these online articles, I do not have that luxury. The length of an article does have space limitations. Therefore, I will vastly condense my description of this option strategy. Once again for simplicity's sake, I will refer to this strategy as a Bull Call.

A Bull Call is done in a way that involves looking at three things: (1) The Fundamentals of the issue, (2) Technical's, and (3) the current I.V. (implied volatility). I love doing verticals on the major U.S. indices or exchange traded funds (ETFs), for this reduces the steps involved from three to two: Technical's and I.V. With certainty, one can claim that those underliers will never get delisted. Hence, fundamental analysis is reduced to economic announcements.

A Bull Call spread is a strategy which could also be used when market conditions are (1) somewhat neutral to bullish and (2) the implied volatility of the underlying is low or in its lower range. Buying a vertical debit spread is much more suitable for the environment that we are currently in than selling a vertical credit spread as described in the previous article.

Once a suitable underlying is selected, locate on the call side of the option chain a call which is two steps ITM (in the money) and another call which is above it. For instance, if the issue is sitting at 496.16, then buying a 490 call and selling a 495 call would make sense; the long option should be purchased at the Ask and the short one at the Bid. The visual depiction in the chart below illustrates my point.

The issue is trading at $496.18 and after buying the 490 call is done, the selling of the 495 call takes place. On many platforms, the two transactions can be performed simultaneously, as it is shown on Figure 2.

Figure 2 highlights not only the strike prices involved but also the Greeks of the spread. The aggregate of the two options' deltas (sold call and bought call) produce a positively correlated delta. Whenever the delta is positive, the position's outlook is bullish by nature. In our example below, the purchased 490 call has a positive delta of 0.6788 while the shorted 495 call has a negative delta of 0.4738. The aggregate of the two deltas (0.6788 – 0.4738) is positive 0.205 and when it gets multiplied by the number of contracts (ten in our case), it becomes 2.05 yet we also need to keep in mind that each contract controls 100 shares. Therefore, 2.05 times 100 gives $205 which is displayed on the Spread Pane portion of TradeStation under the Position Delta. What in fact that number means is that for every single dollar that the underlying moves up, the position will make 205 dollars.

Figure 3 below shows the max cost of $3,600 which comes from buying ten 495 calls at 7.40 and selling ten 490 calls at 3.80 or (7.40 – 3.80 = 3.60) $360 dollars times ten contracts. The maximum loss or max cost is $3,600 while the max profit is $1,400. This number comes from the width of the spread (495 call – 490 call equals five points) and the subtraction of the max cost (5.00 – 3.60).

To figure out the ROI (return on investment) the profit needs to be divided by the maximum cost. In other words, the maximum reward of $1,400 divided by $3,600 equals 38 percent.

Once the 490/495 debit call spread is placed, daily monitoring needs to be done, for this vertical spread does require follow-up action. It is this follow-up action that will produce additional commission. In my previous article on the vertical credit spread (Vertical Spread: Part II), it was possible to have both options, sold and bought, expire worthless. In this case, if the trader lets both options expire worthless, then the trader achieves the maximum loss of $3,600.

Figure 4 above shows the profit and loss of the Bull Call. There are two axes on the chart. The horizontal one displays the strike prices. In our case, the two call strike prices aren't marked on the chart, for our bought 490 call is in between 488 and 492. It is those two numbers (488 and 492) that are shown on the chart. Also, our sold 495 is in between 492 and 496.

The vertical axis shows the options profit and loss. Everything above the horizontal line is profit up to $1,400 and anything below the horizontal line up to $3,600 is a loss. Those numbers also aren't clearly marked on the TradeStation profit and loss chart. Again, the numbers displayed on the vertical line are only listed in the thousands and not in the hundreds.

In conclusion, the aim of this article was to explain the vertical debit call strategy and it was not meant to be a trade recommendation. Have green trading.

Published on  Tue, Nov 3 2009, 13:12 GMT