Not too long ago, a subscriber wrote asking how I had calculated the risk or buying-power effect on a particular spread. That subscriber wanted examples of several types of spreads. I thought the topic might be of interest to others who might be new to spreads of various types.
First, remember that there are three basic types of spreads: horizontal, vertical and diagonal. Each type of spread is opened by selling an option and buying another, but each type has a different risk/reward parameter. I won't be able to cover all those different risks and rewards in a single article, so this article will hone in on one aspect: the buying-power effect. I'm using this term in a broad sense, to mean the amount that's at risk and will be withheld by your brokerage.
It's easiest to start the calculations of potential risk with a horizontal spread, a calendar. This type of spread is initiated by selling a put or call at a certain strike and then buying the same strike put or call in a further-out month. For example, imagine that, with IBM at 119.90 near the close on Friday, August 21, a trader initiated an IBM SEP/OCT calendar by selling 3 SEP 120 calls and simultaneously buying 3 OCT 120 calls. For the purposes of these calculations, we'll use mark or midpoint prices for all options prices and won't consider commissions or fees. I have to stop right here and warn that those commissions or fees do make a difference of course, and will impact the buying-power effect. However, they vary from broker to broker and even from trader to trader at the same brokerage, depending on the agreement with the brokerage, and we have subscribers who use OptionsXpress, BrokersXpress, Think or Swim, Interactive Brokers, and many other trading platforms.
One theoretical calculator for the hypothetical IBM SEP/OCT 120 calendar calculated that the three-lot of this calendar would cost $562.50 plus commissions. That calculator also noted that the maximum loss risk was that same $562.50. Because the short call is covered by the further-out long call, the total risk in the trade is the amount spent to open the trade. That's the risk or buying-power effect that will be withheld by your brokerage.
What about the potential profit? The potential profit will vary with volatility, but the calendar's profit-loss chart has a characteristic tent shape. The maximum profit occurs if IBM ended up at 120 at expiration, so that the sold SEP 120 call was worthless while the long OCT 120 call still had value. As a note, few calendar traders hold out for the maximum profit, instead electing to lock in profit at some percentage of that maximum gain. On either side of the tent shape, the chart shows the potential loss flattening out at -$562.50, with commissions making that loss larger, of course.
Profit/Loss Chart for a Three-Contract IBM Calendar:
Traders should note that if volatility had eased, the maximum profit would have lowered, and, if it had risen, the maximum profit would have risen. This is because the long option, having more time to expiration, has more extrinsic or "time" value, as it's often called. That's what's impacted by changes in volatility. However, for the purposes of this article, we're looking at maximum loss or buying-power effect, that that's the same, no matter what the change in volatility.
Vertical spreads can be of two types: a debit spread or a credit spread. Debit spreads involve the purchase of a long call or put and then the selling of a further-out call or put in the same expiration cycle. For example, if a trader had been bullish on IBM at the close of trading on Friday, August 21, 2009, that trade might have bought 3 SEP 120 calls and simultaneously sold 3 SEP 125 calls. Coincidentally, a theoretical calculator again calculated the cost at $562.50 plus commissions. Because the trader was buying the closer-in calls and selling the further-out ones, the sold calls are covered by the closer-in calls. The total risk would again be the amount spent to open the trade for this directional trade.
What's the maximum profit? I'll show the profit/loss chart and then talk about how the calculations could be made.
Profit/Loss chart for a Three-Contract Bull Call Debit Spread on IBM:
As is obvious, the profit/loss chart for this position looks much different than that for the calendar. The maximum loss is still $562.50 (plus commissions), and the maximum gain, $937.50 (minus commissions). Breakeven for the trade would be at $121.88, if commissions were not included.
How was that breakeven level determined? The strategy cost $562.50 or $1.875 per contract. That means that, in order to collect any profit, IBM has to settle above $120 + $1.875, so that the price of the long SEP 120 call makes up for the cost of initiating the trade. After $121.88--or a little higher, actually, due to the commissions--the trade begins making money. It makes money up to $125, at which time, the gains in the sold SEP 125 strike start deducting from further gains in the long SEP 120 strike. Maximum gain would be reached. That maximum gain is calculated by subtracting the debit paid from the distance between the strikes and then multiplying by the number of contracts and the multiplier for the contracts (usually 100). So, the maximum gain would be ($5.00 - $1.875 debit) x 3 contracts x $100 multiplier = $937.50. This is in keeping with what is shown on the profit/loss chart.
The other type of vertical spread is the credit spread. In this type of spread, a closer-in put or call is sold and then a further-out put or call in the same expiration month is bought to hedge the position. This is also a directional trade, but this time, the trader hopes prices do not go through the sold strike.
For example, if a trader had been bearish on IBM on Friday, August 21, that trader might have sold an OTM SEP 125 call and, as a hedge, bought a SEP 130 call. Because the option that was sold was closer to IBM's then-current price, it would have been worth more money than the SEP 130 call. The trader would have received a credit for initiating the trade. One hypothetical calculator figured that the credit for three contracts would total $195.00, minus commissions. Since the trader gets a credit for initiating the trade, some novice traders might assume that the brokerage won't withhold anything in buying-power effect. However, the risk in this case is actually much higher than the credit taken in, as the profit/loss chart will show.
Profit/Loss Chart for an IBM SEP Bear Call Credit Spread:
In this case, the maximum profit is the credit taken in when the trade was initiated, minus commissions. The maximum loss calculation is found by deducting the credit per contract from the distance between strikes, and then multiplying that by the number of contracts and the multiplier. That calculation for this trade would be ($5.00 - $0.65) x 3 contracts x 100 multiplier = $1,305 plus commissions. This loss is indicated on the chart, and that's the amount that the brokerage is going to withhold in buying-power effect.
Obviously, this loss is much greater than the potential gain and is the reason that credit spreads should be initiated only by those familiar with the risks and benefits of such trades. These are probability-type trades with traders betting on the probability that the underlying won't move through the sold strike. As should be obvious from the chart, these can get into bad trouble quite quickly, and no trader should consider live credit spreads until many cycles of paper-traded credit spreads have been attempted, with at least one of those cycles being a month when they go wrong and have to be adjusted.
Many are familiar with or have the heard the term "iron condor." An iron condor consists of two credit spreads, a bear call credit spread and a bull put credit spread. Credit is taken in on both spreads, so that there's more credit to buffer that big loss, but the maximum loss can still be far more than the credit taken in, depending on how close to the current price of the underlying the sold strikes are.
Diagonal trades are trades in which a closer-in put or call is sold and a further-out put or call is bought in a further-out expiration month, but calculations of profits and losses for these are complicated by the fact that the further-out long call or put is in a further-out expiration period, too.
This article shouldn't be construed as an enticement to trade any particular type of spread. This is far from a comprehensive description of the pros and cons of each type. It was intended to answer a subscriber's question, one that I thought might be of interest to other subscribers. Check out other articles on our site for more information if one of these spreads interests you.