Vertical spreads

The options world is multidimensional and it offers countless ways to implement a trading idea. In this post, I look at debit and credit spreads. Spreads are directional strategies with limited reward and limited risk.

A typical debit spread is long ORCL 25/26 March Call spread. In this case, you are buying the $25 ORCL March Call and simultaneously sell $26 ORCL March Call against it, to decrease the paid premium. The maximum risk is the paid premium. The maximum reward is the difference between the spread (in this case $1) and the paid premium. The main purpose of buying premium via a debit spread is to establish a directional trade and minimize the negative effects of IV and time.

A typical credit spread is short ORCL 25/24 March Put spread. Here we sell a higher strike put to collect the premium and use part of the proceeds to buy a lower strike put, which role is to hedge against unexpected strong decline in the stock. The maximum that we could make is the collected premium if ORCL remains above 25 at expiration date. The maximum we could lose is the difference between the spread of the two strikes and the received premium  (in this case: 1 – .38 = .62 if ORCL closes below $24 at expiration date; see the table below). The main purpose of initiating a credit spread is to establish a directional trade and to get the needed leverage with limited risk. A secondary purpose is to utilize the positive effects of IV and theta.

Let assume that for some reason you are slightly bullish on ORCL for the next 2-3 weeks. By slightly bullish I mean an expectation of a 2-5% move. At the moment of writing, ORCL is traded for $24.82. Let analyze the elements that will impact the premium of ORCL 25/26 March call and ORCL 25/24 put:

What would be the impact on each of the positions if in the next 5 days ORCL goes up $1 to 25.82 and the IV of the contracts decline by 4 percentage points to 20?

In the 25/26 March call spread, the impact of delta would be a gain of $0.2463 per share, the impact of vega will be a loss of (-4)*0.0056 = -$0.0224; the impact of theta will be a loss of 5*(-.0037) = -$0.0185. The overall change in the position is expected to be a gain of $0.2054 or 56% above the base of .36 that we paid. You can see that the effect of vega and theta is minimal in this case and delta is the main driver of profit.

Buying premium by going long a spread reduces the impact of time, but doesn’t eliminate it. In the example, we bought a lower strike call and sold against it a higher strike call in order to minimize the impact of vega and theta. We purchased a spread that is slightly OTM. In order for us to make money, ORCL needs to start moving up and to do it fast, because the more the expiration date approaches, the bigger the negative impact of theta becomes. This is one of the main reasons why I prefer to use short-term spreads to sell premium.

One alternative of going long ORCL via a spread is by selling a put spread for a premium. We don’t have to wait until expiration in order to collect our gain. As the time passes, ORCL price rises and if IV declines, the premium for the 25/24 put will decline and we could purchase it back at a lower price and keep the difference. Let refer to the example.

What will be the change in the 25/24 ORCL March Put spread if the stock goes up $1 in the next 5 days and the IV drops 4 percentage points? The premium will drop – $0.2353 due to delta; 4*(-.0037) = – $0.0148 due to vega; 5*(-.0012) = -$0.006 due to theta. The overall decline will be – $0.2561, which means that the 25/24 ORCL March Put spread will trade for (.38 – .2561) = $.1239. We could purchase it back to offset our position and keep the difference of almost 26 cents per share.

You could see in this example that the effect of theta and vega was relatively small compared to the effect of delta. What does it mean? To make money trading spreads, you need the underlying stock to move in the expected direction and to do it quickly. You need to pay attention to IV. The simple rule to buy short-term premium when you expect the IV to increase is valid here also. Just to remind you, IV tends to rise in expectations of a major event such as an earnings report or when the underlying stock is rapidly declining. Here is a snapshot of ORCL IV:

The chart is courtesy of OX

As a general rule, when volatility is high, options tend to sell at a premium, when low, options tend to sell at a discount. In an effort to trade options successfully, it is important to understand their relative price history. We don’t only want to know if the IV is historically low or high, but also and more importantly if the IV is rising or declining and how far it is likely to go.

ORCL is scheduled to report earnings on March 17th, AMC. As this date is approaching the IV is likely to rise.

After Implied Volatility, the most misunderstood and underestimated topic in the options world is liquidity. There are about 100 stocks and indexes, which options contracts are liquid enough to be traded profitably. Many options traders lose the battle before it even begins. At the moment you get filled on an options spread, you are in a losing position. You paid a commission to your broker. In the case of a bull call spread, you most likely paid the offer price for  your long call and you got the bid price for your short call with higher strike. The lack of sufficient liquidity will put the trader of OTM options and spreads at a huge disadvantage. Not all options are liquid enough to be considered for a trade. In a future post I will come up with a list, revealing stocks, indexes and ETFs which options posses the needed liquidity.

To summarize, it makes sense to buy premium via vertical spreads when:

1) You expect a certain stock to gradually increase or decline in value in the following 3 to 6 months.

2) You want to minimize the effect of IV and theta. You rely exclusively on the move of the underlying stock in order to profit

3) You don’t want to allocate too much capital on this particular trading idea and you don’t want to overpay in terms of risk and time premium.

4) The options contracts of the stock/index you like are highly liquid, therefore you could easily get in and out without losing too much on the difference between the ask and the bid for your contract.

5) The purchased vertical offers at least 3:1 reward to risk. A good example would be buying A three month 40/45 call spread for a debit of 1.20. In this case, your maximum loss is 1.20. Maximum gain is 3.80.

6) Don’t risk more than 1% of your trading capital on any vertical trade. This means that if your capital is 100k and the premium of the debit spread you are looking at is $2, you cannot afford to buy more than 5 contracts.

It makes sense to sell premium via vertical spreads when:

1) you have directional bias for the next few weeks

2) the IV is high and you expect it to decline.

3) You want to profit from theta. With each day, theta will add a little to your position. This is why I mentioned that mainly short-term credit spreads should be considered: 10-15 days before expiration, when the wasting effect of theta is the biggest and it is increasing exponentially.

4) It is preferable to sell OTM credit spreads, because they carry the most time value and therefore will erode more quickly.

5) Don’t risk more than 1% of your trading capital. If you are currently working with 100k and the premium of a $5 spread you like to sell is $2, you cant afford to sell more than 3 contracts. (1% of 100k is 1000 and $3 is your maximum risk  per share)

Unfortunately, this post turned out to be too long for my taste, but I couldn’t make it any shorter without missing some essential points. In the next post, I will share my thoughts on Selling premium – dressed and naked. The first should become one of the favorite strategies of long-term investors, the second is a favorite strategy of many hedge funds.

In-the-money options

Options that are at least 10% in-the-money and have less than 4 weeks until expiration are usually offered for about 1% risk premium. Take a look at the table below. AAPL 180 March Call is currently trading for $21.25, which means that if purchased, the buyer of premium is paying $0.83 above intrinsic value for the right to buy AAPL at 180 until March 19, when it is expiration date.

$0.83 per share more is an insignificant premium to pay for the leverage that the ITM option offers if AAPL start increasing between now and March 19.

Buying 100 shares of AAPL will currently cost  $20,042

Buying one AAPL 180 March Call will cost $2125

Let assume that AAPL will increase by 10 points to 210.42 between now and expiration date.

The equity position will deliver 10/200.42 = 5% gain

AAPL 180 March call will cost $30.42, which means a gain of 43%

For less than 0.5% of the value of the underlying stock, you are buying the right to have 8.5 times leverage if AAPL goes up.

In absolute terms, the potential reward is similar: 100 shares rising 10 points will net $1000 gain. One AAPL 180 March Call at 30.42 will net $917. The difference is the size of the allocated capital. By purchasing the ITM Call you have much more capital left for other ideas.

Certainly, it is not given that AAPL will increase in value. What will be the consequences if the stock starts declining?

It does not matter if you own 100 shares of AAPL and you got stopped at 195.42 for $500 loss or if you own one AAPL 180 March Call  and you got stopped at 16.25 for $500 loss. The risk in absolute terms is the same = $500, assuming that you risk 0.5% of your trading capital per idea and your current trading capital is 100k.

Buying ITM options is strictly directional trade. You have to be right in order to make money. The beauty of the ITM option is that you are essentially paying almost no risk and time premium; therefore your position won’t be seriously harmed by a decline in IV or by theta. You have the privilege to wait almost till expiration date without having to take a significant hit. This is why I like buying ITM options versus OTM options for purely directional trades. With ITM I don’t have to worry about IV and time too much. Unless you are expecting a significant spike in IV, you would be better off by buying 4-5 deep ITM options as opposed to tens or hundreds of OTM options.

In the next post, I will talk about buying and selling premium via vertical spreads. I will address the importance of liquidity and IV for these trades. Here is a quick preview on the subject:

ATM and OTM Options

At-the-money and out-the-money options’ premiums in most cases have small to no intrinsic value embedded in them.

Let take for example MSFT. The stock is currently traded at $28.77

MSFT $29 March call is currently traded at .56

MSFT $30 March call is traded at .22

There is no intrinsic value in any of the mentioned options. If you decide to buy them, you are  essentially paying for the time to be right and to compensate the seller of the premium for the risk he is taking.

Options are bought for three main purposes: leverage, better risk control and hedging. In this post, I am going to focus on the first two.

At this point of time, MSFT is trading at $28.77.

MSFT $29 Call is currently offered for .56. The delta of that particular contract is .46, which  means that for the next 1 dollar upward move in MSFT to 29.77, the $29 March call premium will increase by .46 to 1.02. A 3.5% move in the underlying asset (the stock) results in 82% move in the March $29 call. (it does matter how fast this move will happen, because options are wasting assets and as the time passes the time premium declines with the pace of theta. For this particular call option theta is currently at -.0119, which means that the option premium will decline by .0119 per day, ceteris paribus).

Risk management for an option trader should not be any different than the risk management for a stock trader. Assume that your trading capital is 100k and you are willing to risk .5% of your capital on every trading idea; therefore you are putting on risk $500 every time. In stock trading knowing your risk per trade helps to define the size of your position (how many shares you can afford to buy). In the options’ world knowing your risk per trade helps to define how many contracts you can afford to buy. Every time when you purchase an ATM or OTM option, you should assume that you will lose the whole premium that you pay. Therefore never risk more than you can afford to lose. In this case .5% of your capital or $500 per idea.

You should be a buyer of premium (calls or puts), when

– you have a directional bias: you expect the underlying assets to make a substantial move; for example you might expect a stock to be bid up in front of its earnings’ report date.

– when you expect the IV of your option to increase; What makes an IV of one option to increase? Simply explained – an imbalance between supply and demand in favor of the demand; There are more buyers than sellers for that particular option contract. The impact of IV is measured via vega, which shows the move in the option premium for each percentage point move in the IV.

The current IV of MSFT $29 March Call is 20.5% with a vega of .0316. If the IV doubles from 20.5% to 41%, the premium of that same call option will increase approximately by 20.5*0.0316 = .65.A $.65 increase caused just by the increase in the IV. Assuming there is no change in the stock’s price and the increase in IV happens overnight, the premium of that option should become .56+.65 = 1.11.

When does IV tend to rise?

IV of calls tends to rise in expectations of earnings. As the event approaches, the perceived risk increases and there are more buyers of premium. When I am bullish on certain stock, I like to buy calls 10 to 15 days before the earnings announcement. In this case I have two out of three elements on my side – delta (assuming the stock move in the expected direction) and vega (the increase in the IV). The only element that is against me is theta, but its negative effect is often more than offset by a sizable move in IV.

In the majority of the cases I make sure to sell my calls on the day before the earnings announcement date or earlier. Holding through earnings is usually a gamble, but there are cases when it could be done (I leave that for another post). The reason I tend to sell before the earnings announcement is called volatility crash – an immediate and humongous drop in the IV of an option contract, which affects negatively the premium. Many have lost money in options despite being right on the direction of the underlying asset. People buy a day or two before the earnings report is due, hoping to make a quick gain from a potential gap up on the news. There is no free lunch. In the majority of the cases, those people overpay in terms of IV. If the increase in the stock is not big enough to offset the drop in the IV, the option holder’s position will be in red.

The IV of put options tends to increase in expectation of earnings and when the underlying asset declines in value. Isn’t that perfect. You are bearish on certain stock, it drops and in the same time the IV of the purchased put increases. This is usually the case with the exception of the after earnings announcement volatility crash.

Options are wasting assets and when you are a buyer of premium it is preferable to give yourself more time to be right. The choice to buy 20-day or 180-day option will depend on your goal, analysis of the underlying stock and risk preference. When you are relying mainly on an increase of the IV in front of an earnings announcement, shorter-term options are preferable as the demand for them is bigger and therefore the potential for an increase in the IV higher.  When your intention is to capture a nice size of the move of the underlying stock, it is better to use longer-term options, so you can have more time to be right.

This was the first post of a series of posts,  in which I intend to explain how I use various options strategies, starting from the most simple to the more sophisticated ones. In the next post, I will explain the specifics behind buying  in-the-money options.