Options Interest Council Vertical Spreads A Denver Trading Group Options Interest Council presentation by Ken Sheppard

Review of Option Concepts Leverage Protection Getting paid for that protection

Key Trade Offs Potential risk Probability of profit Potential profit

The Battle Time erosion vs. favorable move in stock price Fewer days to expiration Cheaper Smaller loss Higher probability More days to expiration More time for a favorable move Less price erosion More sensitive to changes in IV

Intrinsic Value & Time Value Stock Price = $ 56.00 50-strike Call Option = $ 9.00 Expiration = 90 days Time Value = 3.00 Stock Price = 56 Option Premium = 9.00 Intrinsic Value = 6.00 Strike Price = 50

Option Pricing Stock Price = $ 56.00 50-strike Call Option (IV = 35) = $ 9.00 Expiration = 90 days TV=9 TV=7 TV=5 TV=3 Stock Price = 56 IV=6 IV=6 IV=6 IV=6 Strike Price = 50 Imp V = 35 Imp V = 50 Imp V = 65 Imp V = 80

Option Pricing Stock Price = $ 56.00 50-strike Call Option (Exp = 90) = $ 9.00 Implied Volatility = 35 TV=5 TV=3 TV=2 Stock Price = 56 TV=1 IV=6 IV=6 IV=6 IV=6 Strike Price = 50 Exp=30days Exp=60days Exp=90days Exp=180days

Call pricing curve

Call pricing curve (cont.) Time value premium is greatest ATM Intrinsic value is zero until strike price is passed.

Call pricing curve (cont.) As IV shrinks, the price curve merges with the intrinsic line. As expiration draws closer, the price curve merges with the intrinsic line.

Time Decay Exp=120days Exp=90days Exp=60days Exp=30days

Long Call +5 45 50 55 60 -5

Profitability Foremost: Secondarily: Favorable movement by the underlying Secondarily: An increase in implied volatility

Which option to buy? “The shorter term your horizon, the higher the delta should be!” Day-traders Use the underlying (2 min to 2 days) Short-term swing traders ITM, short-term (2 days to 2 weeks) Intermediate-term position traders ATM (2 weeks to 2 months) Long-term (2 months to 2 years) OTM, LEAPS

The frustration problem Bid-ask spread Implied volatility changes Risk management

What is a spread? A strategy which involves taking simultaneous but opposing positions in different instruments Being long in the instrument which appears to be under priced Being short in the instrument which appears to over priced The trader hopes to profit when the prices return to their expected relationship

Why spread? Reduces the effect of short-term ‘bad luck’ Reduces short-term risk - Natenberg p133

Vertical spreads Directionality is the primary concern Initially bullish or bearish Remain bullish or bearish regardless of changes in market conditions Volatility is a secondary concern At expiration A minimum value of zero (both options OTM) A maximum value of the spread (both ITM)

Bull Call Spread Sell a call (put) at a higher exercise price Whenever the trader buys the lower exercise price and sells the higher exercise price, the position is bullish! Buy a call (put) at a lower exercise price

XYZ price at expiration Bull Call Spread XYZ price at expiration Oct 30 profit Oct 35 Total 25 -$300 +$100 -$200 30 -300 +100 -200 32 -100 35 +200 +300 40 +700 -400 45 +1,200 -900

Call vs. spread purchase XYZ common, 32 XYZ Oct 30 call, 3 XYZ Oct 35 call, 1 Call does better if price > 36 Spread does better if price < 36 Limited risk BE = 32

Least aggressive (ITM) Stock Larger probability Smaller potential

Aggressive (ATM) Stock Substantial returns if stock price rises

Extremely aggressive (OTM) Stock Inexpensive Remote chance

Position analysis Theoretical edge Delta Gamma Theta Vega position will cross current price above zero line Delta the slope as it crosses is determined by magnitude Gamma ‘ + ’ is convex (smiles); ‘ - ’ is concave (frowns) Theta ‘ + ’ will shift upward over time; ‘ - ’ will shift downward Vega ‘ + ’ will shift upward with increasing volatility; ‘ - ’ will shift downward with increasing volatility

How volatility affects bull spreads Stock price: 25 Time to expiration: 3 months Position: bco at 25 sco at 30 What happens to the price of the spread is implied volatility increases?

How volatility affects bull spreads Stock price = 25 Implied volatility 25/30 Bull call sp (theoretical value) Position vega 20% 1.02 3.69 30% 1.31 2.20 40% 1.49 1.25 50% 1.59 0.71 60% 1.64 0.38 70% 1.67 0.17 80% 1.68 0.03 Interest rate = 2.0%, American style expiration

How volatility affects bull spreads If implied volatility is too low Focus on purchasing the ATM option (the option whose delta is closest to 50) If implied volatility is too high Focus on selling the ATM option

Vertical spread summary Low Volatility Debit High Volatility Credit Bull Bull Call Spread Sell higher call Buy lower call Bull Put Spread Sell higher put Buy lower put Bear Bear Put Spread Buy higher put Sell lower put Bear Call Spread Buy higher call Sell lower call © Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

Which spread is best? Determine the time horizon Decide how bullish or bearish you are The delta of the spread The size in which the spread is executed Focus on the ATM option Assess implied volatility If IV is low, buy the ATM option If IV is high, sell the ATM option Compare cost to expected return © Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

Rules of thumb Do not rank by max profit potential This will always be the OTM spreads Estimate where stock price may advance by expiration Using a trading system Using a Monte Carlo simulator, or Using 2x the time value of the ATM call as an estimate of stock’s advance Compare cost to expected return © Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

Follow up adjustments Stock falls below long strike Close spread as a spread transaction 30 DTE Stock remains below breakeven Close spread as a spread transaction, or Sell long call and let short call expire worthless, or If underlying drops, buy back the short call (< 0.10) & hold the long call, hoping for a rise in price Stock rises above breakeven, but below short strike Close spread as a spread transaction with a small profit Stock rises above short strike If assigned, exercise the long call to deliver shares for maximum profit © Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

Stops Stock stops Exit at 40% or 50% loss If spread doubles, sell half for a free trade Then, implement tight trailing stop Finally, sell remainder at 80% of spread Exit debit spreads before 30 DTE © Gryffindor Global Investments LLC Ken.Sheppard@comcast.net

Option Concepts Leverage Protection Pay for protection