In last week’s article, which you can read here, I demonstrated a double vertical spread. I used the bullish version, which is made up of an out-of-the-money bull put spread together with an out-of-the-money bull call spread. Today we’ll update and extend that example.
This is a highly bullish position. It’s one you might use if you believe the price of the underlying asset could move up a lot, and that’s what you’re trying to get paid for.
Our example uses the gold ETF called GLD, which was at $135 when we started on April 19, 2013. In the prior three months, GLD had traded in a wide range, between $130 and $164. It had just bounced off a major support level at around $130 after a breathtaking drop of over 13% in two days. You could take your pick of conspiracy theories to explain the drop. We took the bullish side, hoping to profit from a recovery in the price of gold.
The double-vertical position I described would pay off a little ($39) if we were sort-of-right to not-drastically-wrong in our bullish outlook, meaning that GLD stayed within a wide range between$125 and $155 over the next three months. It has limited risk in case we are drastically wrong, losing from $105 at our stop, up to a maximum of $461 if gold suddenly were to become worthless. The position could pay as much as $539 if gold takes a rocket ride, beyond $155. The position is little effected by volatility changes, or by time passing (initially). It is very highly directional.
Below is the P/L diagram of the spread, reproduced from last week’s article:
Figure 1 – GLD double vertical as of April 19, 2013
The capital requirement for the spread was its maximum loss, which was $461. This is the $500 we might have to pay to buy back the 125/130 bull put spread if gold tanked; less the $39 net credit we initially received for the whole position. Remember that the maximum value of any vertical spread is the difference between its strikes. On this 120/125 put spread, that difference is $5 per share. We would have to pay this $5 only if we kept the spread until expiration, and GLD was below $120 at that time. In that case, the 150 and 155 calls would be worthless; both puts would be in the money; and our short $125 put would be worth exactly $5 more than our long $120 put at any GLD price.
But we planned to exit long before that, if GLD dropped below a support level that bottomed out at $127.80 (the week of January 28, 2011). If that happened right away, our loss would have been $104.66 with unchanged IV; or up to about $130 if IV increased by a third (not shown on the chart). If the drop to our stop price took longer, our loss would be less than those amounts. If that drop took long enough, it would actually result in a profit of up to the whole $39 initial credit.
Now for the update. By the morning of April 25, GLD was up a little over $6, to around $141. Implied Volatility was down slightly, from 23.9% to 22.4%. Our Double-vertical position was in the green by about $75. The P/L chart as of this time is shown below.
Figure 2 – GLD Double Vertical as of 4/25/13
Note the following on this diagram. Understanding these points will help expand your ability to visualize option positions:
- In this position, we are mainly counting on an increase in GLD’s price to make a profit for us. The upward-slanting blue line (today’s P/L line) shows that higher GLD prices (prices farther to the right on the graph) lead to better Profit/Loss figures (higher values on the vertical P/L axis). Upward-slanting P/L curve = a bullish position.
- The Current Day P/L line (blue slanted line) crosses and re-crosses the Expiration P/L Line (Green zig-zag line) at different GLD prices.
- At prices at which the blue line (today’s line) is above the green line (expiration line) , P/L is higher today than it will be at expiration if GLD is still at that same price; it follows that at those prices the passage of time hurts us – we have negative Theta. At prices where the blue line is below the green line, P/L is not as high today as it will be at expiration; so at those prices the passage of time helps us – we have positive Theta. The black vertical lines show the theta switch points, although the prices are not labeled for space reasons. Below about $122.78 theta is negative (blue line above green). Theta becomes positive at $122.78 then becomes negative again at $138.70, finally becoming positive again above 152.16.
- The reason that theta switches back and forth between positive and negative, is that four separate options are involved. Each of them has a certain amount of time value, which changes with GLD price movement. Each option has its maximum time value when GLD is at that option’s strike price. As GLD moves away from that strike, in either direction, the option’s time value decreases. Meanwhile, the next option in the position sees increasing time value as GLD’s price approaches it. As GLD moves upward between $125 and $150, for example, our $125 short Put starts out with a lot of time value, while our long $150 call has very little. We’re short a lot of time value and long a little, so we are net short time value, and so time’s passing helps us. If GLD continues upward that $125 Put becomes further and further out of the money. Meanwhile, our $150 long call becomes less and less out of the money as GLD moves toward its strike. At some point (which in this case is at the black vertical line at $138.70), the time value we own in the $150 call exceeds the time value we owe in the short $125 put, and we become net long time value.
- As price moves higher still, all the value is gone from the puts, so they’re out of the picture. Above $150, our long $150 call loses time value as it goes deeper into the money. All that time value, and more, is replaced by intrinsic value; still the time value portion is declining. At the same time, the short $155 call is gaining time value as the price of GLD approaches it. At the next crossover point at $152.16, the diminished time value in the $150 call becomes less than the increasing time value in the short $155 call, and we are once again net short time value. This will be a very comfortable position, if it happens. At that point, further price increases, if any, will continue to build our P/L; and we need be in no hurry to exit, since time will also be on our side.
So as of April 25, we had a respectable open profit in the trade, and GLD was a (relatively) comfortable distance away from our stop. We knew that further price increases would help us, although for the next few dollars’ increase in price we were becoming temporarily increasingly vulnerable to time decay. We’ll stay the course here, and give further updates in the future.
Next week will be the final installment on the setup of this trade, where we’ll look in detail at the effects of time and volatility near expiration time. There are some effects there that may surprise you.
For comments or questions on this article, contact me at firstname.lastname@example.org.