option strategies

  1. 1,047 Posts.
    The following is an extract from a newsletter that I recieve from option1.com.au

    I find the newsletter an interesting alternative to the standard hard sell, any other useful newsletters on options about?

    Any way the tech piece of the newsletter was about call spreads.

    "For a call spread, you
    would sell one strike and buy a strike above it. For a put spread, you would
    sell one strike and buy a strike below it. For both the calls and puts, the
    maximum profit is the net premium or credit received and the risk is the
    difference between strikes less this credit. Both the maximum risk and
    maximum reward would be seen at or very close to expiry, but of course these
    spreads can be traded in and out before that time.


    face=Verdana> 


    face=Verdana>Time decay has the
    most positive effect on the strategy when the short option is closest to the
    underlying market price (closest to-the-money). The further you move
    out-of-the-money, time decay still works in your favour, but the effect gets
    less drastic.


    face=Verdana> 


    face=Verdana>For in-the-money
    spreads, time decay actually works against you as, in theory, the bought
    option would be trading with greater time premium.


    face=Verdana> 


    face=Verdana>Trading a spread from
    the perspective of time decay can be classed as non-directional. That is
    caring less about the direction of the market and more about the behaviour of
    the options given the passage of time.


    face=Verdana> 


    face=Verdana>The interesting thing is the credit spread can also be a
    great directional strategy.
    Again, and
    perhaps unsurprisingly, this has a lot to do with the selection of strike
    prices.


    face=Verdana> 


    face=Verdana>From a mathematical
    viewpoint it all comes down to your net position delta. To generalise, a far out-of-the-money
    spread, be it a call or put spread, is not going to have much of a delta and
    therefore will not move very much in reaction to the market itself. You could
    consider this particular strategy as non-directional.


    face=Verdana> 


    face=Verdana>However as you move
    closer and closer to-the-money, the difference between the delta on the sold
    option and the bought option will widen meaning the position will have a
    larger net delta and therefore be more responsive to the market. style='font-weight:bold;font-style:italic'>In other words, it will be more of
    a directional trade.


    face=Verdana> 


    face=Verdana>For example,
    let’s look at the ASX200 index, last at 3142 and consider a short dated
    option. Logically speaking, trading in strike prices say 500pts
    out-of-the-money would mean your net position would not move very much along
    with the market. In other words you would have a low position delta.


    face=Verdana> 


    face=Verdana>As you move closer to
    the money however, things start to change. Let’s model this using a
    50-point spread differential, 15% implied volatility and 50-days to expiry:


    face=Verdana> 


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    lang=EN-AU style='font-size:10.0pt;font-weight:bold'>Call Credit Spreads


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    color=navy face=Verdana>Sold leg


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    color=navy face=Verdana>Bought leg


    style='width:60.65pt;border:none;border-bottom:solid windowtext 1.0pt;
    background:#E0E0E0;padding:0pt 5.4pt 0pt 5.4pt;height:12.75pt'>

    color=navy face=Verdana>Spread value


    style='width:48.0pt;border:none;border-bottom:solid windowtext 1.0pt;
    background:#E0E0E0;padding:0pt 5.4pt 0pt 5.4pt;height:12.75pt'>

    color=navy face=Verdana>Max risk


    style='width:50.1pt;border:none;border-bottom:solid windowtext 1.0pt;
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    color=navy face=Verdana>Total Delta


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    face=Verdana> 


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    lang=EN-AU style='font-size:10.0pt;font-weight:bold'>Put Credit Spreads


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    color=navy face=Verdana>Sold leg


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    color=navy face=Verdana>Bought leg


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    color=navy face=Verdana>Spread value


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    background:#E0E0E0;padding:0pt 5.4pt 0pt 5.4pt;height:12.75pt'>

    color=navy face=Verdana>Max risk


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    background:#E0E0E0;padding:0pt 5.4pt 0pt 5.4pt;height:12.75pt'>

    color=navy face=Verdana>Total Delta


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    face=Verdana> 


    face=Verdana>The first thing to
    notice is the positive or negative bias of the position delta. For the call
    spreads, delta is negative indicating a bearish bias. For the puts, it is positive
    indicating bullishness. It
    is also interesting to note the total position delta peaks with strike prices
    near the underlying price.


    face=Verdana> 


    face=Verdana>You see the more the
    strikes are in-the-money, the closer both deltas will move to 1.0 and the more
    they are out-of-the-money, the closer they will both move to zero. At-the-money is
    where you will see the biggest difference in deltas. (The net deltas by
    themselves may not be huge, but the effect depends on how much you trade.)


    face=Verdana> 


    face=Verdana>Clearly each spread
    has it’s own degree of what we might call directionality. What then is the most
    directional trade? There are two ways to look at this: by strike price or by
    delta.


    face=Verdana> 


    face=Verdana>If we consider the
    strike price only, then you would have to say the deepest in-the-money spread
    is the most directional. You see it takes more for the market to move to a
    point of maximum profit and you can earn more from it per contract.


    face=Verdana> 


    face=Verdana>Take for example the
    3050 (bought) and sold 3000 (sold) call spread. If we entered the trade at
    these prices, we would receive 38pts in credit. This is the maximum profit
    potential should the market fall to below the sold strike 3000 at expiry.
    Should the market stay above 3050 until expiry, the spread price would move
    towards the net intrinsic value of 50pts and therefore a maximum loss of
    12pts would be seen.


    face=Verdana> 


    face=Verdana>Should the market fall
    by a large amount (below 3000) you stand to make a decent amount. Also as the
    market falls and falls towards the strike price, the net delta will increase
    meaning your position
    becomes more sensitive
    .


    face=Verdana> 


    face=Verdana>But what about a
    smaller move in the market? What strategy is more directional then? This you
    can tell from the net delta. For both the put and call spreads, net delta is
    greatest for strikes closest to-the-money.


    face=Verdana> 


    face=Verdana>So what is the point?
    What can we draw from all of this?


    face=Verdana> 


    face=Verdana>Well getting back to
    the subject of time decay, the at-the-money spread has the best potential to
    profit from time decay. This week we have said the at-the-money spread will
    also show the most immediate reaction to a move in the market.


    face=Verdana> 


    face=Verdana>Now it’s tying
    together. Credits spreads can therefore be traded to profit from a short-term
    directional move in the market and respond positively to time decay.


    face=Verdana> 


    face=Verdana>Contrast an
    at-the-money call credit spread with buying an at-the-money put option. These
    are both bearish strategies. But if the market stays flat, one will make
    money and one will lose thanks to time decay. This ignores what you might pay
    for the put and what you could make, but it does show there is more than one
    way to look at it.


    face=Verdana> 


    face=Verdana>As for credit put
    spreads, the same goes. The net delta is however positive showing a style='font-weight:bold;font-style:italic'>bullish
    market bias
    but the spread will also benefit from time decay when at- or
    out-the-the-money.


    face=Verdana> 


    face=Verdana>From now you can
    consider credit spreads as another tool you can use for a certain outlook in
    the market. You will also know the difference between choosing one set of
    strike prices over another.


    face=Verdana> 


    face=Verdana>If you are new to the
    concept, it is worthwhile to put pen to paper and model a range of different
    spreads – their risk, return and deltas. It is good practice. "

 
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