TK All-Star posted on 10/30/09 at 09:21 AM

Dan Passarelli continues exploring credit and debit spreads.

Welcome back to my mini-series on vertical spreads. In my last post. we discussed debit spreads and credit spreads, the two types of vertical spreads.

We also reviewed how, because of synthetic relationships, a debit call spread is essentially the same as a credit put spread, and a debit put spread is basically the same as a credit call spread. The only real difference is the cash transaction—debit or credit—at the time when the spread is initiated. The potential risk and reward, however, is the same once interest and dividend issues are taken into account. This concept can have an important impact on your psychology when managing an ongoing vertical spread trade.

Let’s quickly review these two strategies before moving on…

Vertical Spreads: A Quick Recap

Vertical spreads come in two types: debit and credit spreads. As the name implies, with debit spreads you pay for the spread upfront, hoping it’ll gain in value and can be sold for a higher price later. A debit spread with calls is set up like this:

•    Buy a call, Strike Price A

•    Sell a call, Strike Price B (Strike B is HIGHER than Strike A)

•    Generally, the stock will be at or above Strike A and below Strike B, and both options will have the same expiration month.

Commissions at TradeKing are $11.20 to enter this debit spread for 1 contract.

The max potential risk is the net debit paid upfront, while the max potential profit is limited to the difference between Strike A and Strike B minus the net debit paid. Learn more about this strategy under Education > The Options Playbook > Play #13 Long Call Spread.

Spreads are multiple-leg options strategies involving additional risks and multiple commissions and may result in complex tax treatments. Keep the risk of early assignment in mind when constructing your own trades. Consult with your tax advisor as to how taxes may affect the outcome of these strategies.

With credit spreads, you get cash (or “credit”) upfront and hope to buy the spread back later at a cheaper price. A credit spread with calls looks like this:

•    Sell a call, Strike Price A

•    Buy a call, Strike Price B (here, Strike B is HIGHER than Strike A)

•    Generally, the stock will be below Strike A, and both options will have the same expiration month.

It costs $11.20 in commissions to enter this credit spread for 1 contract.

Again, the max potential profit is the net credit received upfront. The max potential risk is limited to the difference between Strike A and Strike B, minus the net credit received. Learn more about this strategy under Education > The Options Playbook > Play #14 Short Call Spread.

The Psychology of Trading Verticals

Imagine you’re buying an out-of-the-money debit call spread — say a 50-55 bull call spread, with the underlying stock XYZ at $49. With this trade you’d gain positive delta, positive gamma, negative theta and positive vega.

(If you’re not familiar with delta. gamma. theta or vega. TradeKing’s Options Guy has written great posts explaining each of these so-called “Greeks”. In a nutshell, delta and gamma refer to the relationship between an option’s price to the underlying’s price. Theta refers to the impact of time decay on an option’s price, and vega refers to the impact of volatility on an option’s price. You can look up the Greeks for any position at TradeKing by going to Accounts > Holdings – Options View.

Let’s put some specific numbers to this example:

Out-of-the-Money (OTM) call debit spread

With XYZ at $49, you…

Buy 1 November 50 XYZ call at 2.50

Sell 1 November 55 XYZ call at 1.00

Net debit: 1.50

Delta = + 0.35

Gamma = + 0.09

Theta = — 0.01

Vega = + 0.04

It costs $11.20 in commissions to enter this debit spread for 1 contract.

You get a positive delta because you bought the call with the closer-to-the-money strike. Positive gamma, negative theta and positive vega result from the underlying stock being closer to the long (50) strike than the short (55) strike.

Those positive delta and gamma values mean the trade benefits if the underlying stock price increases. Negative theta, however, means you’re vulnerable to time decay. Positive vega means your spread will gain value if implied volatility (IV) increases.

With this trade established, you’d want the stock to move higher — to or through the short strike, and you’d want it to happen fast. Why? To avoid the impact of negative theta, eating away at your trade with time decay.

Now imagine the underlying stock does rise quickly to $56 a share. How would this move impact your trade’s Greeks?

In-The-Money (ITM) Call Debit Spread

With XYZ now at $56:

Long 1 November 50 XYZ call at 7.25

Short 1 November 55 XYZ call at 3.50

Net debit currently: 3.75

Delta = + 0.35

Gamma = — 0.09

Theta = + 0.01

Vega = — 0.05

It costs $11.20 in commissions to enter this debit spread for 1 contract.

Note the delta is still positive, but the signs of all the other Greeks are reversed. Now your trade faces negative gamma, positive theta and negative vega. In other words, positive delta and positive gamma means the trade benefits if the underlying stock price increases. Positive theta means you’re also benefiting now from time passing. Negative vega means you’re now vulnerable to volatility swings – if implied volatility (IV), increases, your spread will likely lose value.

You’re getting positive delta from the fact that the 50-strike calls have a higher delta than the 55s. But now the short strike is the dominant influence. With the stock closer to the 55 strike, negative gamma, positive theta and negative vega prevail. At this point, you’d have made some of the maximum profit from the long delta, but you’d still have to wait it out to reap the remainder from theta, or time decay.

Incidentally, these Greeks would be about the same as they would be for a 50-55 credit put spread. You should also keep in mind that Greeks don’t stay static: even if absolutely nothing is happening in the market, time is ticking away daily. Greeks tend to move in tandem, so consider this just a snapshot in time.

The Blurred Line Between Debit and Credit Spreads

You’d now face a choice. Door Number One: should you close the position to take a partial profit? Door Number Two is to wait it out and hope the stock remains above $55 a share until expiration. If you stay in, you’d need to be ready to manage this trade as if it were a 50-55 bull (credit) put spread.

This can be a big psychological leap for some traders. It’s not a credit spread; it’s a debit spread. But imagine for a minute that you didn’t have this position. If, at $56, you believed the stock would stay flat or continue higher, you might consider selling a 50-55 credit put spread. You’d monitor the trade and wait out time decay, maybe hope for some gain from the positive delta if the stock continues higher. This is effectively the same position, and the same mindset, you should now bring to this existing ITM debit call spread.

Remember the box trade we discussed in part 1? Using this theoretical trade, we showed last time that these two spreads are synthetically the same. If you recognize the flip-flop that can occur from debit call spread to synthetic credit put spread, it can help you manage the trade effectively. It can also help you see more clearly how to view the trade after the stock moves higher.

Regards,

Dan Passarelli

In reading content in the Trader Network, 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.

The Greeks represent the consensus of the marketplace as to the how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct.

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.

Dan Passarelli / Markettaker maintains a cross-marketing relationship with TradeKing.