This interesting question comes from a TradeKing client with the Trader Network name “kbd”. He describes the setup as follows: “I excitedly placed my first trade; a bull call spread using LEAPS (expiring on 01/22/2011) on Dow Chemical Company (DOW). The stock recently did climb to the higher strike price of the call sold short, thus reaching maximum profit potential – or so I thought.
“However, I am very disappointed with the actual rate of return (as compared to the rate of return that I initially calculated). I placed the trade on April 14, 2009, by buying the 10 call strike price and selling the 17.50 call strike price for a net debit of $248.21.
The rate of return that I initially calculated was 202% [(17.5 – 10) x 100 – $248.21 / $248.21]. On May 08, 2009, the stock closed right at $17.50, with a net bid, mid, ask for the spread at a credit quote of $3.50, $4.10, $4.70, respectively. If I sold at the mid point ($410) my actual rate of return would only be 65.18% [($410 - $248.21) / $248.21 = 65.18%], and not the 202% as initially calculated. I am not quite sure why there is such a large discrepancy between the expected and the actual rate of returns?”
So you are only up 65% on this trade, eh? The first thing to correct is your sense that a 65% return isn’t stellar. Congratulations on hitting your long spread’s short strike so soon.
Now it’s time to recalibrate your expectations for what the trade’s profit potential should have been. First, it’s important to note a spread usually reaches its maximum profit potential when the short option has little or no time value remaining. That means you’re usually hoping for your move to the short strike to happen closer to option contract’s expiration date for that to be achieved.
To answer your question, I used TradeKing’s Profit + Loss Calculator, which you can find under the Tools menu. Your trade is pictured below:
I have outlined several things in red boxes that I would like to talk about. First thing are the Price fields in the bottom center of the screen. I replaced the prices in the box with the prices you indicated that the trade filled at.
I then plotted the stock on the graph right at 17.50 – that’s the red line. At this point, the P+L Calculator estimates the profit at expiration at $500 (gold line) and the profit at with 621 days left is at $125.60 (blue line); you’ll see this dollar information in the lower right of the graph boxed in red. Keep in mind: this is just an indication of profit and loss and not a guarantee. The Profit + Loss Calculator makes many assumptions on volatility levels and the price of the stock, not to mention other variables like interest rates, all of which may not hold true in the real marketplace.
I have also highlighted the Net Delta of the position, which estimates the position delta to be 21.486. That suggests that, for this 1x1 long call spread, if the stock increases by $1 the net dollar amount the position may increase by is $21.486, and if the stock decreases by $1 the position may lose $21.486. This is why you weren’t getting the movement you were expecting, mainly because the short option was fighting against the long option the entire way up. The delta of the short leg will have some fighting power until more time passes. Now, if we were already at expiration and the stock was at the strike the short option would be basically worthless and not have much fight in it all.
If we break down the position delta, this’ll start to be clearer. The delta for the short option position is a negative 62.758, and for the long option position is a positive 84.224, netting out to 21.486 (- 62.758 + 84.224). Those deltas will change as expiration nears, taking most of the “fight” out of the short leg.
I usually do not go out much further than 45 days when doing long spreads for exactly this reason – that’s a rule-of-thumb, of course, not a hard-set rule. Obviously, the issue with the 45 days is this: if the stock does not make the move desired in this time period, the longer term spread looks better.
There’ll never be a golden rule-book showing you the correct thing to do on complex option trades, but using the Profit + Loss Calculator before doing the trade will set your expectations more realistically as to the profit potential of the strategy before entering the trade. What’s more, it can also really assist you in choosing your time period.
Read on!
If you’d like to get even more familiar with these topics, check out the following resources:
If you’re a TradeKing client, login to the Options Playbook under Education and look for Play #13, Long Call Spread.
Check out my blog series on long call spreads: Part 1, Part 2, Part 3 and Part 4.
There’s a video tutorial and written help guide on the Profit + Loss Calculator – look in the upper right-hand corner of the screen. The tutorial is just 10 minutes long and will really familiarize you with all the advantages this handy tool can give you.
Last but not least, I did a one-hour educational video on bull call spreads at the Chicago Board Options Exchange (CBOE) on bull call spreads, too.
Hope this clears up your questions.
Regards,
Brian Overby
TradeKing's Options Guy
www.tradeking.com
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