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Sunday
Oct142012

Vertical Option Spreads Explained by SK Options Trading

One of our more favoured options trades is the vertical spread, aka strike spread. Vertical spreads can be constructed with puts or calls and can be bullish or bearish. To the unfamiliar, these sorts of trades can be difficult to conceptualize. The aim of this article is to break these trades down into simple terms, to explain their dynamics and pros and cons of such trades and why they could be useful to you.

To aid in your understanding we’ll use one of our recently closed vertical call spreads that banked a 70.24% profit as an example throughout.

To start right from scratch, there are two types of options – puts and calls.

The buyer of a call has the right (but not the obligation) to buy a certain number of shares in the underlying asset at a specified future date. If you think the price of gold is going to go up, you buy a call.

A put is the exact opposite, giving the buyer a right (with no obligation) to sell a certain number of shares in the underlying asset at a specified future date. If you think the price of gold is going to go down, you buy a put.

For the purposes of this article and to illustrate the dynamics of our recently closed call spreads, we will focus only on calls for the remainder of this article.

To buy anything, first someone must sell it to you and options are no different. For every buyer of a call there is another person writing or selling that contract.

The range of variables inherent in option trading can make it harder to grasp initially, as opposed to simply buying or selling shares. The main points to observe are:

Expiration Date: This is the date in which the option is settled.

Strike Price: This is the agreed upon price between buyer and seller at the time of entering into the contract that determines whether the call is exercised or not and how much each party gains or losses at expiration.

Our recently closed call spreads were made up of two calls, but more on that later. For now we are just focusing on one of the calls, which are identified by:

GLD Jan 19 '13 $170

GLD refers to the underlying asset. GLD is an ETF that tracks the price of gold, but it is technically no different than buying Google or Wal-Mart options since GLD trades as a US stock.

Jan 19 ’13 refers to the expiration date. This option is settled on the 19th of January 2013.

$170 is the strike price of the call. If the price of GLD is above $170 on 19th January 2013 then the buyer exercises the option. If the buyer has the right to buy GLD shares at $170 and the price on that day is $180 for instance, they have made a $10 profit because they can sell their shares they bought at $170 to the market for $180.

If the buyer exercises their right to buy the underlying, the seller or writer of the call must sell it to them at the agreed upon (strike price) and hence they lose the same amount that the buyer gains.

The final parameter we’ll look at is the option price or premium.

This is the ‘market determined’ value at which someone will write/sell a call to the buyers.

The price we paid for our GLD Jan 19 ’13 $170 call was $3.34. The diagram below shows the profit/loss of this call at expiration for various GLD prices on that day.

Immediately one can see the payoff is unlimited. If GLD had of risen to $190, the $170 call would be worth $20, from just a $3.34 investment! 


On the other side of the coin, if GLD closed below the strike of $170, the downside is limited to the cost of the option - $3.34! That is why we trade options so much – there is the potential to create unlimited upside with limited downside that is observable before purchase!

How about the seller of this option? This is what their payoff looks like:

It is the exact opposite of the buyer’s diagram. For the seller, their upside is limited and known to $3.34 but there is unlimited downside! This seems like a scary proposition, risking infinite losses to make $3.34 - and it can be!

Now we’ve explained the difference between buying and selling calls we can move onto explaining the dynamics of our call spread!

Firstly, the lower the strike price of a call, the more expensive it will be. If GLD is currently at $170, it makes sense for a $180 call to be worth more than a $250 call. The current price is much closer to $180, and hence there is a much greater chance that GLD will be greater than $180 at expiration than it will be above $250, and hence the $180 call is more likely to be worth something more than the $250 call. Therefore, buyers are willing to pay more for the cheaper call and sellers demand more to take on the risk of selling a cheaper call.

Call spreads involve buying and selling two identical options in every respect other than their strike price.

We mentioned earlier we bought the $170 call to construct half the vertical spread. To build the other half we sold a $175 call. The $175 call we sold for $2.50, therefore the net cost of this spread was $3.34 (cost of $170 call) - $2.50 (credit received for selling $175 call) = total cost of $0.84.

Our combined payoff looked like this:

The blue line shows the payoff of the sold $175 call, the orange shows the bought $170 call and the black line is the combined payoff of the vertical call spread.

For prices between 170 and 175, the $170 call is increasing in value. The $175 call is out of the money and hence still worth $2.50 to us. Therefore the net payoff rises between $170 and $175.

Beyond $175, our $175 call goes into the money and is potentially exercised by the buyer (although options are rarely ever exercised before expiration and we never hold an ‘in the money’ option until expiration) losing us more the higher GLD goes. Unlike the situation where one sold a call in isolation the unlimited downside of this sold $175 call is offset by the unlimited upside of our $170 bought call when they are combined! As a result, the net payoff is limited. Beyond $175 the unlimited upside and downside of our respective calls cancels out and the payoff is unchanged.

From this we can conclude the following. One can see from the graph the black line of the combined payoff cuts the Y axis higher than the orange line. The interpretation of this is the vertical spread is cheaper to buy than the $170 call outright.

This makes sense because the cost of the spread is simply the cost of the $170 call, minus the sale price of the $175 call. Because the price of the $175 call will always be greater than zero, the combination of the two calls will always be cheaper than the $170 call on its own.

A cheaper entry price is certainly a big advantage when making a speculative investment!

Between $170 and $175 on the chart, it is clear to see the spread returns more, and gets into positive territory quicker than the $170 call outright. This is a function of our previous conclusion. Because the price of the vertical spread is lower than just the call, the spread moves into profit sooner.

The outright $170 call doesn’t generate more profit than the spread until GLD reaches $177.5 when the orange line crosses up through the black line.

Therefore as an options play, a vertical call spread is a used when one is bullish, but not extremely bullish. The standalone call only generates more profit beyond prices of $177.5. But the return (value/cost) of the call does not exceed the return of the spread until GLD passes $190; which explains our tendency to use vertical spreads as part of our trading strategy.

If one gets it wrong and the share price does not increase, losses are much less significant with a vertical spread than they are with an outright call.

So the question must be asked, why, if we are still bullish on gold did we close this trade before it expired?

Firstly, the golden rule of investing – no one ever lost money taking a profit.

Secondly, we shifted the capital we had invested in the $170/$175 spread into a more speculative trade with greater upside! Decreasing gamma made it a prudent decision to reallocate the profit on this trade into another. Gamma is a more complex concept, those with a bit of calculus experience may enjoy reading up on, but is perhaps a subject that requires its own explanatory article.

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