I’ve been talking about a Double Vertical spread in the last two weeks’ articles, which you can read here and here. Today I’ll wrap up that example with some observations about how its behavior changes as expiration approaches. Understanding these changes will help us to “know when to hold ‘em and know when to fold ’em” in these and many other situations.
As a quick review, our position is composed of the following, all entered on April 19, 2013. All prices are per share:
Short Vertical Put Spread (AKA Bull Put Spread, AKA Credit Put Spread)
Short 1 GLD July 125 put at $2.13
Long 1 GLD July 120 put at ($1.33)
Net Credit: $ .80
Long Vertical Call Spread (AKA Bull Call Spread, AKA Debit Call Spread)
Long 1 GLD July 150 Call at ($ .84)
Short 1 GLD July 155 Call at $ .43
Net Debit: ($ .41)
Net Credit for Combined Position $ .39
Below is last week’s P/L diagram of the position.
Figure 1 – GLD Double Vertical as of 4/25/13
Here are the lessons I want us to take from this example this week:
Notice that the “today’s P/L line” (blue line) appears to be almost a straight, upward-slanting line. This is just what we were looking for when we entered this bullish trade – a profit from higher GLD prices. At the time we put this trade on, I noted that all the Greeks aside from Delta – that is Gamma, Vega, and Theta – were of very small magnitude. This meant that the passage of time or changes in volatility would have very little effect on the position – only the price of GLD would have much impact.
All of the above holds true until the July 20 expiration date draws very near, and then things start to get much more interesting. About a month from expiration, around June 21, things change dramatically. If we were still in the position at that time, then we’d have some decisions to make. So first of all, would we ever be in the position that close to the expiration date?
That depends. In general, we don’t want to hold options that are net long time value during the last two months of their lives. During that last two months before expiration, time value declines at a rapidly accelerating rate, so we don’t want to own it then. For that same reason, when we are short time value, we do want to maintain those positions, possibly right into expiration, to take advantage of that period of rapid time decay. When we are net short time value, the only way we make our maximum profit is for all the time value to disappear. That normally means waiting for expiration.
In this Double Vertical position, our status as either being long time value or short time value, depends on the price of GLD. I described this in more detail last week. At some prices we are long time value (and therefore have negative Theta), at others we are short (and have positive Theta). This is shown by the “Positive Theta” and “Negative Theta” labels for different GLD price ranges in the green boxes above.
Wrapping your mind around this switching between positive and negative theta is the main point of this exercise.
Below is another chart, this time showing three separate P/L lines in addition to the green “at expiration” line.
Figure 1 – GLD Double Vertical as of 4/25/13
Note the following about the above chart:
- The box labeled Chart Values shows the amount of profit or loss this position would show, per contract, on several different dates in the future, with GLD at a price of 150 on those dates. These dates are, first, the day of this writing (April 29); second, June 21, when things begin to change rapidly; third, July 15, just five days before expiration; and finally July 20, expiration day. The July 15 date was chosen to show how much difference there is in just the last 5 days of the options’ lives.
- The magenta line, which will be the “today” P/L line on June 21, is very close to the blue (April 29) “today” line at most prices. This means that things don’t change very much between April 19 and June 21, except for whatever effect the changing price of GLD has. Time’s passing will not have had much effect during this time, nor will changes in volatility.
- Notice in the Chart Values box that at a GLD price of $150, the values of Plot1 (the April 29 P/L line) and of Plot2 (the June 21 P/L line) are almost identical at $214 and $217; while the values of Plot3 (July 15) and Plot4 (July 20) are radically lower, at $144 and $39 respectively. This means that after about June 21, the passing of each day does make a very big difference. This is in stark contrast to the time before June 21, where time and volatility hardly mattered at all.
- The highlighted price range is the area of maximum danger, in this sense: In that price range (about $145 – 152), once we pass June 21, the “today” P/L line suddenly breaks away and races toward the “at expiration” P/L line – which is DOWN. In that price range, if we’ve gotten too comfortable with a nice open profit and are not paying attention at that time, our gains will quickly evaporate. At a GLD price of $150, in the 2 weeks after 6/21 (to 7/5), our open profit would drop by $70, from $214 to $144, as shown by the values in the box of Plot2 and Plot3. In the next 5 days (7/15 to 7/20), it would drop another $105, all the way to $39. All this while GLD stands still at $150. We would certainly not want that to happen. If price is in that range, it’s much safer to get out with a nice profit around June 21.
- The exact reverse of point 4 is true if the position is short time value when we reach June 21, and we’re still in it. That would be the case if GLD were in the range from $127.80 – 138.00, or above $152. In those low or high price ranges, the further passing of time helps us, and we’d want to hold until expiration.
So our management strategy for this position can be broken down into the low-gamma phase (up to June 21 – when the P/L line’s curvature is barely changing) and the high-gamma phase afterward (When the P/L curvature is changing fast). In the low-gamma phase up to June 21, the strategy is simple: Exit if GLD drops below our stop at $127.80, otherwise hold.
In the high-gamma phase after June 21, the strategy is also simple, but different: Exit if GLD is below the stop at $127.80, or if the position is long a large amount of time value (between $145 and $152); otherwise hold until expiration.
(There is one further, fairly unlikely possibility: If GLD soars so far above the $155 call strike that that call loses its time value, that would also mean that all the other options have lost all time value as well. We would exit with our full profit, no matter when that occurs. The price at which the $155 call would lose all time value is quite high, but drops each day toward the $155 strike.)
It should be clear that this position is certainly not a “set-it-and-forget-it” trade. It needs a definite plan for management, and the ability to make such a plan is crucial to profiting from it. The key is this: This need to analyze and plan applies not only to this fairly exotic example, but also to many seemingly simpler ones – including all “simple” vertical spreads.
A related goal of this example has been to show that the effects measured by the various Greeks are dynamic – they all change with time and price. Hence the shape-changing P/L curves. That dynamic nature is not a problem – it’s a source of profit when we have the diagramming tools and the know-how to visualize the changes. Mastering the art of visualizing our positions will help us to excel as option traders.
For questions or comments on this article, contact me at firstname.lastname@example.org.