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intro to spreads
Long Call Vertical
Analyzing the risk profile of a long call vertical
Variation In Strike Price
Let's take a look at how selection affects this strategy. Studying these concepts can help you understand how to customize your vertical to accommodate your profit goals, capital limitations, and risk tolerance.
Standard Setup
Starting with a basic set up, in the example below we sold a 25Δ call against a long 75Δ call. Both calls have $0.50 of extrinsic value, which establishes our break even directly at the current share price. Our POP is 50%, and our maximum profit and maximum loss are exactly equal: $250 ($2.50 × 100). This is a classic risk 1 to make 1 scenario – a coin flip. As you can see by the delta at the bottom of the graph, this position has a 25% probability of expiring at max profit, and a 25% (100%-75%) probability of expiring as a maximum loser.
Narrow Strikes
In this example, we have narrowed the width of our strikes by $3, resulting in a $2-wide vertical. The long strike costs a debit of $2.15, while the short strike brings in a credit $1.15. This results in a net debit of $1. By narrowing the width of our strikes our probability of profit remains at 50%, but we have lowered our maximum potential profit and loss. Our maximum potential profit is now only $1, while our maximum potential loss is also only $1. There is also a far greater chance of the position expiring at max profit or loss... 40% odds as opposed to the original 25%.
Take note that tight strikes such as these will create friction between each other. This is because their deltas are closer in value, causing the options to almost cancel each other out. The result is a much slower P/L rate. Consider our original $5-wide spread. We were short the 25Δ strike, and long the 75Δ strike. Combining the two resulted in a 50Δ position (75Δ - 25Δ). As you may remember from previous articles, we can use delta to estimate several attributes – one of those being share equivalence. Our 50 positive deltas indicate the position should profit or lose at the rate of about 50 long shares. In the narrower $2-wide spread, our net delta is only positive 20 (60Δ - 40Δ). This means the P/L is only expected to change at a rate of about 20 long shares – less than half the speed of the wider vertical. The moral of the story is, wider spreads result in faster, more volatile positions. Narrower spreads produce slow-moving vehicles.
Wide Strikes
Next, let's examine an even wider vertical. In the example below, we have an $8-wide spread. The long costs a debit of $4.15, and the short leg brings in a credit of $0.15, resulting in a net debit of $4. Both legs have $0.15 of extrinsic value which cancel each other out, producing yet another 50% POP. This position has a net delta of positive 80 (90 long - 10 short), meaning its P/L will change at a rate similar to 80 shares. The maximum profit is $4 (×100), as is the maximum loss. This is a lot of risk, especially compared to the $2-wide spread. The odds of expiring at either maximum, however, is only 10%. A position like this might be useful if you wanted to simulate the risk profile of 100 long shares while only using a fraction of the buying power. For example, if this were a $200 product, 100 long shares would require thousands of dollars to hold. An 80Δ debit spread could profit at almost the same pace but, in this case, would only require $400.
Deeper ITM Long Strike
What would happen if we skewed our strikes? In other words, what if we selected strikes that weren't equidistant from the share price. Let's see what happens when we sell the 40Δ strike which is $1.00 above the share price, and buy the 90Δ strike which is $4 below the share price. Assume the 40Δ brings in a credit of $1.15, and the 90Δ costs a debit of $4.15. The result would be $5.00-wide spread with a net delta of positive 50. It would cost a total debit of $3.00, which is also the maximum potential loss. The maximum potential profit would be the width of the strikes, less the debit paid: $5.00 - $3.00 = $2.00.
There are several interesting features to note about this setup. The most glaring feature is the profit to loss ratio. Placing this trade would require you to risk $3.00 to make $2.00. You'd have to risk more to make less, but in return you'd be compensated by probability. The odds of expiring at max loss on this trade would be about 10%. This is compared to the 45% probability that the position expires at maximum profit.
Secondly, we have to look at the net extrinsic value of the position. We paid $0.15 of extrinsic value for our long option, and collected $1.15 of extrinsic value for our short option. This means we've collected $1.00 ($1.15 collected - $0.15 paid) of positive extrinsic value. Whenever we collect extrinsic value on trade entry it improves our break-even. In this case, the break-even is moved $1.00 in our favor giving us some buffer room to be wrong. The share price could fall by $1.00 before our break-even is breached. This puts our POP right around 60%. Collecting that extrinsic value also does another thing for us... It puts time in our favor at trade entry by creating positive As time passes, should the share price stay the same, go higher, or even slightly lower, our position will slowly profit off the decay of the extrinsic value. Over time, even the smallest advantages can pay off. Keeping the odds in our favor is one of the sharpest weapons in our arsenal.
Farther OTM Short Strike
For our final example, let's see what happens if we skew our vertical in the other direction. We'll buy the 60Δ call ($1 below the current share price) for $2.15, and sell the 10Δ call ($4 above the current share price) for $0.15. This would result in yet another $5.00-wide vertical with a net delta of 50, and cost $2.00. This setup has many similarities to our previous example, except this time you are risking $2.00 to make a maximum of $3.00. You are risking less to make more but in return you are giving up advantageous odds. In this scenario, you have a 40% probability of expiring at maximum loss, and only a 10% probability of expiring at maximum profit.
Just as we did in the last example, we should also examine the extrinsic value in this position. We paid $1.15 of extrinsic for our long call and collected $0.15 of extrinsic for our short call. We actually paid a $1.00 for this position. The more premium (extrinsic value) you pay to establish a position, the lower your POP is going to be. In this case it pushes our break-even $1.00 against our favor, reducing our pop down to about 40%. We are also creating negative theta decay. This means that as time passes, our position will lose money by default. It isn't until the share price rises by $1.75 or so that your theta will start turning positive. You can see this where the black dotted P/L line intersects with the solid expiration line in the graph. The dotted line will slowly shift toward the solid line as time goes by. As it currently stands, the dotted line (you're P/L) must decline into loss to meet this requirement. If you're interested in making high probability trades, this one would not meet your needs.