Welcome back! My last post in this series dealt with the tight interrelationship between options pricing, implied volatility and the trade's overall probability of success. In the last post, I kept things pretty concrete -- but today we're going to dive into a little more theory and complete the picture. Another example: debit spreads
First, let's finish what we started by running through a debit spread, which is a slightly different calculation than last week's credit spread. We're basically going to flip the legs in last week's example, buying where we sold in the short/credit spread and vice versa.
Apple @ 136.04
Buy AAPL Sep07 145 Call @ 2.55
Sell AAPL Sep07 150 Call @ 1.45
Net debit -1.10
Max gain = 5 - 1.10 = 3.90
Max loss = 1.10
Breakeven = 145 + 1.10 = 146.10
Plugging all this information into TradeKing's Probability Calculator (under the Tools menu) yields a 24.26% probability of the trade finishing above our breakeven point of 146.10. That figure comes from adding two probabilities together: 7.12% chance of a finish between the two strike prices, plus 17.14% chance of finishing above the highest strike, 7.12 + 17.14 = 24.26 (see screen capture below).
[To enlarge this picture in a separate window please click here.]
Thinking of it in "quick and dirty" math (explained in previous post), we're risking 1.10 on a 5-point-wide spread (1.10/5 = .22), giving us an estimated probability of 22% by using the price of the spread in the marketplace.
Misconception
It might seem initially that the long spread in this example is a "better" trade from a risk/reward perspective than the short spread discussed in my earlier post. After all, we're only risking 1.10 (the net debit paid) for the potential to make 3.90 (5 - 1.10). In the short spread, by contrast, we're risking 3.90 (5 - 1.10) to make just 1.10 (the net credit received). Here are the specs once more in my previous example, the short credit spread:
Apple @ 136.04
Buy AAPL Sep07 150 Call @ 2.55
Sell AAPL Sep07 145 Call @ 1.45
Net credit +1.10
Max gain = 1.10
Max loss = 5 - 1.10 or 3.90
Breakeven = 145 + 1.10 or 146.10
When you evaluate both trades based on probability of success -- the long spread at 24.26% and the short spread at 75.73% -- it's clear that neither trade is better. In fact, they're both "fair" relative to the potential movement the market place is implying in terms of IV. Even though the risk-reward ratio might seem more attractive, the long spread is actually more of a speculative trade, because you need the stock to finish up 7.6% or 10.46 points (146.50 - 136.04) at expiration just to breakeven. On the other hand, the short spread - where we're risking 3.90 to earn 1.10 - becomes profitable if the stock finishes anywhere below 146.10. In other words, because the long spread requires such a sizable move just to breakeven, its higher max gain is justified.
Advanced summation
In a perfect utopian marketplace where theory always holds true, when it comes to option trading there is no such thing as a "better" strategy. If options are efficiently priced and stock prices are log-normally distributed (as most pricing models assume), Trader A could put on bazillions of short spreads with the same risk reward but different stocks, while Trader B traded bazillions of long spreads with the same risk reward but different stocks. In the long haul both traders should have the same profit and loss, when all the trades were said and done. Sometimes the long spreads would win big, but most of the time lose. Most of the time the short spread would win a little amount and every once in a while lose big.
Then again, that's the utopia of theory. We all know the markets are anything but utopian -- that's part of the challenge of trading them.
Next week, I'd like to talk about collars, another strategy we touched on in the long call spread series. Stay tuned!
Regards,
Brian (OG)
[image: yellow rope with knot by limonada on flickr]
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed or securities mentioned, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities.