Damn
sorry, the expiration dates are supposed to be the same.
Here's what the options should have read in my original post:
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Buy 3 MER
Jan $95 Calls @ $3.80
Sell 2 MER
Jan $75 Call @ $14.90
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So it's meant to be a vertical spread (not a horizontal or calendar spread).
So taking that into account, I should be able to use an equation, right? if so, why aren't mine working.
Sorry for the confusion.
I'll read through your responses and learn from them anyway, but if you could respond taking the above correction into account it would be greatly appreciated.
Thanks.
Hello rapidex,
Your maximum loss AT EXPIRY should you hold till then would be if MER (US Market) closed on $95 for the scenario you outlined would be $2160 ($4000 - $1840).
The 2 sold calls are (US options are 100 shares per contract) worth $20 per share ($75 calls with the underlying at $95), hence 200 shares times $20 = $4000. This is the maximum loss for the sold component.
You entered the position with a credit of $1840.
Subtract the credit ($1840) from the loss ($4000), and the theoretical maximum loss at expiry is $2160.
Now, why are you trying to work out the break evens? The Maximum loss is at the tip of the “V”, while the theoretical break evens (AT EXPIRY) are above and below this in price. They are different things – have a look at the attached graph.
Have a read of my comments below, and I’ll explain why what you are doing (while admirable as a learning exercise) is not going to help you in the actual execution of this kind of spread (which I love, but you have to know how to use these in practice, and WHEN – and in what situation).
Also, I just looked at your original post more closely – the original version had the sold call with the longer time to expiry – an altogether different animal! (Not possible I think with most brokers, and not advisable).
Rapidex – READ THIS PART!!!
Trying to work this out at expiry while helpful in a theoretical sense is actually a waste of time in practice because you’re looking at the wrong end of the trade – you’re looking at what it would look like at expiry, something some brokers tend to look at to determine margin (erroneously in my view). Certainly you need to know the maximum risk, but a good options program should automatically tell you this.
In my view your trading rules should have you exiting this kind of spread well and truly before expiry would allow this kind of significant loss to occur. Hence only experienced players should get involved with this kind of spread and have developed risk mitigating rules to avoid the worst case scenario.
What you should be looking at very closely is the positive and negative effect of VOLATILITY (BIG HINT) which is if you know what you’re doing going to be a major threat to this kind of position, and being able to simulate the effect of volatility crush or rush is critical since even if the underlying moves in the way you think it will, volatility can turn a theoretical winner into a market loser. Watch out! (Incidentally, theoretical losers can actually do ok in volatility rush scenarios, but you need to work through this via trial and error).
Since you are likely to exit well before expiry (at least I’d hope so), you need to work out the time value component and the volatility component, and to some extent the effect of theta decay. The strikes you choose, the ratio you choose, the space between the strikes, and the time to expiry are all going to matter a lot, and of course there is Volatility!
Each strategy will have unique characteristics, and it is your job to work out the best strategy based on an assessment of the probabilities in part based on straight risk to reward, but also on your assessment of how volatility and price action will play out, and when.
See the chart below which has different lines running through it based on different times (see the small analysis table with legend) and this is assuming flat volatility. Volatility rush and crush can greatly effect the theoretical values even for this, hence you have to work out where MER will be (in price) and WHEN.
The break evens are only relevant to the expiry line, hence in my view potentially misleading unless you intend to sit through to expiry…
Break evens are fine with vertical spreads you intend to hold through to expiry, but I’d suggest looking at different strategies to do this, straight ratio back spreads are generally either for very aggressive directional plays, or in some cases for highly volatile markets where a large move is expected in a direction, but an adverse move is possible of great magnitude. It is the alternative spread of choice for those who prefer back spreads over straddles and strangles, eliminating many of the problems with theta decay, but for a trade off.
In my experience it is rare to find a good ratio back spread to trade straight off the bat in terms of finding enough skew (although it is possible, just unlikely, and you need to be set up to take advantage of these).
In practice unless you are an expert fully set up to trade these strategies, it is often far better to sell the second leg to lock in profit at a time where the volatility has increased, aiming to buy low volatility, wait, and sell at a point where volatility spikes up later irrespective of the price (although playing the price and counter trends of course can be important depending on how you want to play these, just don’t forget the importance of VOLATILITY).
I hope that answers your question, and I added some food for thought as a measure too...
Kind Regards
Magdoran