One of the great things about trading options is the tremendous amount of creativity that can be used to create new ways to make money. Although there are a few dozen “standard” option positions that are listed in any option reference, these can always be combined to make positions that fit your exact outlook.
One of the ones I like is the double vertical spread. This is a position where you have a strong bullish or bearish opinion about future price direction. If a very large movement in your direction does occur, it pays off handsomely; if price goes against you your loss is limited; and if price stays stagnant at the current level, or makes a modest move in your direction, it makes a very small profit.
Here’s an example. The price of gold, as represented by the ETF called GLD, has had a very wild ride recently. Since making all-time highs at $185.85 in September 2011, GLD has been in a long downtrend. Last week, after trading around $152, it made a sudden 14% drop, touching a low of $130.51. As that price drop occurred, the Implied Volatility (IV) of GLD jumped from around 12% to over 30%, as put buyers scrambled to buy protection. By Friday IV had backed off some, to a level of 23%, still about double its recent level. GLD’s chart as of April 19, 2013 is shown below:
Without arguing the merits of the argument about the price of gold, for the sake of example, let’s suppose that we believed that this sudden drop was overdone, and that gold would most probably rebound, moving back in the next few months toward the area of $160-165 where it last traded in February. The pivot reversal whose low was at $127.80 in January 2011 should hold; if GLD fell below that we’d give it up and bail out.
The situation with Implied Volatility is very fluid, and we’d need a position that would not be hurt by pretty large changes in IV either way.
One way to create a strongly bullish position that fits these requirements is to use the Double Vertical. In this case, we’d start with a Bull Put Spread with its short strike below our $127.80 bail-out point, at $125. We’d go out to July to give our rebound time to work, and sell the July 125 puts. To complete the bull put spread we’d buy the July 120 puts. On the morning of Friday, April 19, using prices that were at the midpoint between the bid and the ask prices for each option, this spread could have been done for a credit of $.80 per share: selling the 125 put for $2.13 and buying the 120 put for $1.33.
Next, to capture some of the upward move later in the rebound, we would use part of the credit generated by the bull put spread, to buy a bull call spread at higher strikes. In this case, the 150-155 bull call spread would cost $.84 for the 150 call, less $.43 for the 155 call, or a net debit (money out) for the bull call spread of $.41. Subtracting this $.41 debit from our $.80 credit on the bull put spread gives us a net credit (money taken in) for the entire position of $.39 per share.
Below is the P/L graph for the combined option position:
Here are the relevant points about this position, as we can see from the diagram:
- The bold green lines represent the P/L curve at expiration. The upward-sloping blue line represents the P/L curve as of today (April 19). The small green dot on the blue line at the current price of $134.78 shows the current status of the position.
- At the current price, theta is positive (the green dot on today’s blue line is at a lower P/L value than the green at-expiration line). Time’s passing helps us at this time and price.
- Note that the individual parts of the position, the bull put spread and the bull call spread, are enclosed in the gold boxes.
- If GLD stays above $125, the 120/125 bull put spread pays – we keep its $.80 credit.
- If GLD does stay above $125, but does not rise above the $150, then our 150/155 bull call spread will be worthless, taking away its $.41 cost from our $.80 credit on the put spread. In that case we would just keep the $.39 total position net credit.
- If GLD rises above $150, then our 150/155 bull call spread will have value, which we’ll get in addition to the original $.39 credit. Every penny above $150 is a dollar in our pocket on top of the original $39.
- If GLD exceeds $155, our total profit maxes out at $539, as detailed below.
- Max profit per share on the bull call spread alone is (difference between strikes – bull call spread cost) = (155 – 150 – .41) = $4.59 per share = $459 per contract.Max profit on the bull put spread alone is the credit on that spread, which was $.80 per share = $80 per contract.
- Max profit on the bull put spread + max profit on the bull call spread = ($459 + $80) = $539.
- At the current price, theta is positive. If price rises, we’ll go through a period of negative theta until price rises further, enough so that the current day’s line at that time once again crosses above the expiration line (straight green line). Above that price, theta becomes positive once again, and remains so.
Finally, let’s look at the value of the Greeks on this position.
- Delta at this time is about +14. The position makes some money immediately from any increase in price. Should price rise above the 150 strike of our bull call spread, our net delta would rise rapidly. In that case the 150 calls would have over a 50 delta, and all the rest of the options would net out to a very small offset to that.
- Theta at the moment is positive, but that can change as described in point 11. above.
- Gamma at this time is only .03, meaning at this price, P/L is not very sensitive to movement. Standing still is just about as good as moving up.
- Vega is minimal at only .21. The effect of any change in Implied Volatility has been effectively neutralized.
So there we have it. A strongly bullish position with a good risk/reward ratio; that makes some money as long as price simply doesn’t drop any more than down to our stop at $127.80, which would be another 5% drop; makes big money if price takes off above $150; and is immune to changes in IV. If we’re extremely bullish, it could be just what we’re looking for.
A final note: this is a very aggressively bullish trade, since we’re buying an out-of-the-money debit spread, which is a very speculative trade indeed. In this case we’re buying it with the proceeds from a credit spread that has a very high chance of paying off. If we were not so aggressively bullish, we could simply do the bull put spread alone.
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