Nehemiah and MNX
This All-Star Commentary post features a Trade Note from Nehemiah. Thanks for filling us in, we appreciate your contribution!
"It appears that the NDX has finally broken out of the range it has been trading for the last three weeks. From this point, I expect mainly upward movement in price but I'm hedging by selling the 180 call. This note is being posted a couple days after the trade as I got busy with my day job. Now, I can see that Stochastics, CCI, MACD and RSI are all confirming price." - Nehemiah long call spread entry
Nehemiah,
There are some interesting things going on here that we should point out. "Upward movement" with "hedging....calls." What does this mean? Also, your trade is in MNX, yet you reference NDX in the trade note. Why is that? Let's go to the Rookie's Corner to begin.
ROOKIE'S CORNER
As of 3/27/08 close: As of 3/19/08 close
MNX = 177.79 MNX = 171.56
NDX = 1777.89 NDX = 1715.59
3/19 Trade 1: Bought to open 1 MNX April 175 calls @ 6.02
3/19 Trade 2: Sold to open 1 MNX April 180 calls @ 3.47
Spread trade: Bought 1 MNX April 175-180 call spread @ 2.55
Long Call Spread - Play #13 (Education > The Options Playbook > The Plays > Play #13)
A long call spread gives you the right to buy stock at Strike Price A and obligates you to sell the stock at Strike Price B if assigned.
This play is an alternative to buying a long call (Play One). Selling a cheaper call with higher Strike B helps to offset the cost of the call you buy at Strike A. That ultimately limits your risk. The bad news is, to get the reduction in risk, you're going to have to sacrifice some potential profit.
BREAK-EVEN AT EXPIRATION
Strike A plus net debit paid (175 + 2.55 = 177.55)
THE SWEET SPOT
You want the stock to be at or above Strike B (180) at expiration, but not so far that you're disappointed you didn't simply buy a call on the underlying stock. But look on the bright side if that does happen - you played it smart and made a profit, and that's always a good thing.
MAXIMUM POTENTIAL PROFIT
Potential profit is limited to the difference between Strike A (175) and Strike B (180) minus the net debit paid. (180 -175 = 5 - 2.55 = 2.45)
MAXIMUM POTENTIAL LOSS
Risk is limited to the net debit paid.
MARGIN REQUIREMENT
After the trade is paid for, no additional margin is required.
AS TIME GOES BY
For this play, the net effect of time decay is reduced. It's eroding the value of the option you purchased (bad) and the option you sold (good).
IMPLIED VOLATILITY
After the play is established, the effect of increasing implied volatility is somewhat neutral. It will increase the value of the option you bought (good) and the option you sold (bad). So if you choose to close your position prior to expiration, implied volatility is not a huge concern on this play.
TRADE DISCUSSION
Ok, so back to "hedging." I don't mean to get picky here, but the casual and often use of this term when trading a spread is one of my gripes with the option education community. Before I get on my soap box, let's define it for everyone's sake.
Hedge - to protect an investment against unwanted risk, while still being able to profit from the underlying investment activity
To give you a real world example, replace "investment" with the word "business" in the above sentence. Congratulations, you are now a happy owner of an airline company! You make money by providing airplane travel to customers for a fee. The higher your costs, potentially the less money you make. Your biggest cost will be jet fuel. In making assumptions about your company's future needs for fuel, you can hedge against its rising cost. As crude oil rises, so will the cost of jet fuel. An investment in crude oil may provide protection against this unwanted risk. It will not be full proof and it will not be 100%, but this hedge will provide significant protection. Hedging also comes at a price. The cost of hedging and the transaction costs you incur for placing the hedge should not be so high that it negatively impacts the business viability.
Saying you were "hedging" in your Trade Note was probably an innocent inclusion on your part. The term is really not one to be used when describing this kind of spread because of the weight it carries. To explain further, the term hedge is a strong word with potentially strong characteristics, offering significant protection.
Teaching options to Mr. and Ms. Public is a role I and many others handle with care. As such, we use words with caution, choosing our remarks carefully. When individuals use the word "hedge" when teaching about a call spread, they may not mean to be harmful. But I find the term irresponsible, because it gives the investor a false sense of security both when placing the trade and during the life of the position. I have spoken to many investors who think they cannot lose money in the trade, and that is simply not the case.
Although selling the higher strike call reduces the overall cost of the trade, it does not provide any protection to the investor. I reserve the terms protection and hedging for strategies like the Protective Put (Play 7) and the Collar (Play 8). Keep in mind, just because you can hedge, doesn't mean you can't lose money. As I mentioned, hedging is not free and can add a large expense to a trade or investment.
You may certainly understand the pros and cons of the position, but I wanted to highlight this point in the hopes of preventing other investors from having confusion on this topic as mentioned. Sorry you are getting caught in the jargon "cross-fire."
Catch my follow up post which will discuss MNX, NDX, and the relationship between them.
This comment and any market data included here were prepared on 3/28/08.
TradeKing Staff
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