To Spread or Not to Spread

TK All-Star posted on 06/17/08 at 09:58 AM

Lawrence McMillan discusses "The Question" and some key factors.

 

You're bullish on Valero and an options trader. You have many ways to skin this cat with the two most common ones being to buy calls or buy a call spread. What should you do? As you might expect, there are pros and cons to both strategies. Before we move on to Lawrence McMillan's commentary, Nicole Wachs will handle the set-up.

THE PLAY - Long Call Spread

 

TRADE FORMATION

On May 19th the trader bought VLO June 50 calls (Strike A) at a price of 2.30 and sold VLO June 52.50 calls (Strike B) at a price of 1.25. The same day VLO stock closed at $49.65 which is close to where you usually want the stock when entering this trade. This is a bullish trade with an upside target (Strike B or higher) and is an alternative to buying long calls outright.

Although the width of the strikes chosen can vary, they seem a little tight here (50 and 52.50). The month chosen (June) gives the stock some time to make a move without giving going too far out. The break-even point at expiration is 51.05 (Strike A plus spread debit). The sweet spot is the upside target of 52.50 or higher. The most you can make on this trade is 1.45 (Strike B - Strike A - spread debit). The most you can lose is the spread debit of 1.05 (2.30 - 1.25). The trader is risking less than s/he hopes to make, which is positive, but usually a favorable reward to risk ratio is usually coupled with a lower probability of success.

FIELD CONDITIONS - the trading environment

If you have been trading options, you have realized that there are many factors that can affect your trade. The same applies here, but the single most important part of this play is the location of the stock in relation to 50 (Strike A). If one were to buy calls outright, there are two important parts - where is the stock and what is the outlook on implied volatility. To better understand "fair value" and "expensive options" in the next section, you may want to check out Dig out your Ginsu Knives by Nicole Wachs. For "Delta", please read Understanding Delta by Brian Overby.

ALL-STAR COMMENTARY - by Lawrence McMillan

The trader in this case has established a bull spread because, it seems, he feels a little uncomfortable with the risk of buying into a rally.  Per spread, he is risking 1.05 (plus commissions) to make 1.45 (less commissions), maximum, at June expiration (which was about five weeks away upon initiation).

The trader has not given us any idea of how long he intends to hold this spread, but let's view it as a position that might be held all the way to expiration. Running this trade through my Expected Return Calculator, we see that is has a small expected loss. Why? Because there is no real edge in this trade.  Both options are trading for about "fair value," when valued with a volatility estimate of 40% -- which is right in line with the recent historical volatility of VLO.

Click here for a larger image of Figure 1.

But, the computer (i.e., the Calculator) doesn't express an opinion on the stock price movement.  The fact that the expected return is negative just means there's no theoretical "edge" in this spread.  If the stock rises, this spread will make money - but so would an outright call purchase.

This brings up one of my general rules about spread trading.  If there is no theoretical edge in a directional spread (a bull spread is a directional spread - that is, the stock has to go up in order for this spread to make movement; a non-directional spread can make money even if the stock doesn't move, as in a calendar spread, for example), then you probably shouldn't spread.  In other words, I would prefer an outright purchase of call options here rather than establishing this spread.

The best time to use a bull spread is when the options are expensive.  Simplistically, the reason for that statement is that you may be risking too much in terms of buying high implied volatility if you merely buy an expensive call.  But you can mitigate that expensiveness by also selling an (expensive) out-of-the-money call to compensate for having to overpay for the call you are buying.  But these VLO options are not overly expensive.

So, a bull spread is not really justified for this trade.  Even if one thinks that VLO will exhibit volatility slightly lower than 40% over the next few weeks, these options are not overly expensive.

I also think that a bull spread should involve a relatively wide distance between the striking prices, so that the spread has a good chance to widen out, even if the stock makes a modest upward move.  If one sets the striking prices too close together, there won't be much widening of the spread unless a) expiration is near, or b) the stock rises by a great deal.  For example, consider Figure 1, which shows a profit graph of this position.  The pink line shows the projected profits on June 2nd (today) two weeks after the spread was established.  The box on the upper left of the graph shows that if the stock has risen to 53 by that time (which is above the higher strike, and thus in the maximum profit area), the profit is only $50 out of the maximum potential profit of $145.  That's because when the stock is just slightly above the higher strike, the maximum profit won't be achieved until much closer to expiration.

This fact comes as a surprise to many traders not familiar with bull spreads.  The way to counter this is to widen the distance between the strikes, so that a 3-point move by the underlying will produce a bigger profit.  Another way to state this is to say that the delta of the spread will be higher if the strikes are spread farther apart.  With a higher delta, the spread will capture a larger percentage of any upward stock price movement.

In summary, a simple call purchase would be a better choice here.  If the trader is uncertain about buying into a rising stock price (although, in the bigger picture, VLO is actually in a downtrend), then he can mitigate risk by buying a smaller quantity of options.  He doesn't have to enter an inefficient bull spread to try to cut down on the dollars risked in the trade.

--Lawrence G. McMillan

President

McMillan Analysis Corporation

All-Star Commentator

 

For a list of previous All-Star Trades, please click here.

Would you like your Trade Note to be chosen? Read more.

This comment and any market data included here were prepared on 5/29/08.

 

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.

While Delta represents the consensus of the marketplace as to the theoretical price movement of the option relative to the underlying security there is no guarantee that this forecast will be correct.

Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.

Lawrence G. McMillan has a professional business relationship with TradeKing.

Edited by TK All-Star at 09/03/11 at 07:19 AM

Share this! Report

Posted by TK All-Star on 06/17/08 at 09:58 AM

Comments

You must Log In to post to this blog.

Not a member? Register Now to …

  • See what other traders are doing
  • Make your own trades public
  • Share your thoughts on a trade
  • Join or start a group
  • Connect with like-minded traders