Last week I noted that Implied Volatility (IV) in general had moved higher, after being at an extremely low level for months. The last year’s range for the IV of the S&P 500 Index was from about 11% to 25%. That gives a median around 18%. In the week of February 18 the S&P’s IV rose to 15%, much nearer that median. This development meant that we should begin to select different option strategies.
Last week I started an example of a bullish Horizontal spread on the SPY. With SPY sitting on a demand level around $150, and with a supply zone overhead at around $154-155, I believed that SPY could rise back to $154 within days to weeks, and was unlikely to drop below $149.50. I also believed that at a level of 15%, IV was more likely to rise than to fall, but did not want to count on that as the sole source of profit.
I described a Bullish Horizontal spread on the SPY as of February 21, 2013. We bought the May Calls with their strike price at our $154 price target, paying $1.90, and sold the April 154 Calls at $1.15, for a net debit of $.75 per share ($75 per spread). Using a strike price above the current price is what makes this a directional trade (bullish in this case). If instead we had constructed this spread with At-the-money (ATM) strikes, it would be price-neutral. If we were bearish, we would have done it with puts and used a strike below current price.
The payoff diagram for that strategy is shown below.
Figure 1 – Bullish Horizontal Spread payoff graph at inception on 2/21/13
Here’s how the three main option variables would effect this position:
Delta: Positive, as long as SPY does not exceed the $154 strike price. If the price of SPY went up, both the May and April 154 calls would increase their “moneyness” (become less out-of-the-money), so both would increase in value. The Mays have a higher Delta so they will be affected more by underlying price changes.
But if the price of SPY increased a lot, beyond our $154 target, our delta would become negative – our profit would begin to decline, and eventually turn into a loss. Huh?
One way to understand this is to remember that when an option is very deep in the money, it has a great deal of intrinsic value but no time value. Time value only exists when there is a chance, and not a certainty, that an option will expire in the money. If there’s no chance (because an option is very far OTM) the option has no time value – in fact it has no value at all. Look far enough along the option chain, and you will see strike prices where the bid and ask are $0.00. On the other hand if expiring ITM is a certainty (because an option is very deep ITM), that option will have no time value either. The deeper in the money the option gets, the more expensive it becomes, but all of its value is intrinsic value. Once again, looking at the other end of the option chain will show ITM strike prices where the option price is almost exactly its intrinsic value (no time value).
In this case, think about what would happen if SPY were at a very high price, say $175 at the April expiration. In that case, both the April and May $154 calls would be far in the money. So far, in fact, that both options would have no time value at all. Both would sell for their intrinsic value of $21. So we’d have to sell our May options for $21 and buy back our April options, also for $21. The net value of the spread would be zero ($21 – $21). But we paid $.75 to buy the spread in the first place. Since we couldn’t get anything for the spread in this situation, we would lose that original $.75 cost.
The downward slide in our P/L starts at the $154 strike price, where our profit peaks. We would plan to liquidate this position if SPY reached that price.
Theta: Initially negative, turning positive if our expected price increase occurs.
Remember that our Theta is positive (we make money from the passage of time) whenever we are short time value. When we are long time value, time decay hurts us instead of helping us.
Looking at figure 1 above from left to right (from lower underlying asset prices to higher), we’d have a net long time value position at any asset price where today’s P/L curve falls above the expiration P/L curve (blue line above green line). We would be net short time value whenever the “today” curve (blue line) is below the expiration P/L curve. I’ll call the price range where we are short time value the Positive Theta Range. Note that the range changes by the minute as both the blue and the green lines move.
In figure 1 above, that range is between about $151 and $156. On Figure 2 (5 days later and 3% higher in IV), the range had widened to between about $151.50 and $157.50.
Vega: Positive. Increasing IV causes both curves, the Today curve and the Expiration curve, to shift upward in the center area, and widens the profitable price range.
So how did this trade work out?
As it happened, on February 26 SPY dropped below our stop price of $149.50. Since breaking our stop price meant that we might have been wrong on the direction of SPY, it was time to close out the trade. Here’s what the payoff diagram looked like on that day:
Figure 2 – Bullish Horizontal Spread payoff graph on 2/25
Note these points from the two diagrams:
1. The green curve is the profit or loss at April expiration at the indicated prices for SPY. Its maximum value is higher in figure 2 ($110) than it was in figure 1 ($82). The increase in IV meant that the excess time value we owned was more valuable at any price of SPY.
2. By the time our $149.50 stop price was hit, IV had increased from around 15% to over 18%. That increase in IV pushed upward on both the April and the May 154 calls. It had more effect on our long May calls, since they have an extra month of time to go and therefore more time value. In fact, the increase in IV almost offset the drop in our position’s value that was caused by the $2 decline in SPY. When we exited, our loss was only $.08 per share.
3.If IV had increased even more, the “today” line (blue line) would have shifted upward even more. If IV had increased another percentage point or so, we would have broken even at our stop price.
4.Most importantly: We have no intention of riding these curves up or down their whole length. For us, the relevant part of the P/L curve is only the part between our stop price and our target price.
As you can see, there is quite a bit below the surface of this simple strategy. Understanding its dimensions will help you to use it to profit in the right circumstances.
For comments or questions on this article, contact me at firstname.lastname@example.org.