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Q & A. Buying a call spread

Hi
Mark:

I have a question about the break even point in a vertical
spread.

Example: When I buy a Jan 2010 Bull Call spread on a stock
that is trading at $227.69, the long strike is $230 and the ask is $2.70;  short strike is $240, and the bid is $0.20.  The difference is a
debit of $2.50, or $250 per contract.

My understanding is that: I am not making any money until the price
of the underlying stock gets past $232.50 (my break even),which is the
$2.50 I paid plus the $230 long call strike price. At $232.51 I am
making money, but until then I am only recouping cost.

Is there another method of calculating the break even, to show when my trade is profitable? excluding the commission.

***

Hi Irene,


Good to hear from you again.

There is much more to your question than appears on the surface, and I thank you for the opportunity to discuss this topic.

1) Important note:  The idea behind buying a spread, rather than buying a single option – is to reduce the cost of your investment. That reduces risk.

In your example, the option you sell is priced at $0.20, and makes very little difference in the cost of your investment.  Reducing that cost from $270 to $250 is not the right thing to do.  If you were reducing the cost from $0.80 to $0.60, that would be a significant reduction in cost, and thus, represents a good opportunity for entering into a spread position. 

I would not bother selling the call at such a low price.  First, the spread limits profit potential.  And that's fine when you get something in return for doing that.  $20 on a $270 investment is not good enough.

Second, it gives you almost no added safety.

Third, you must pay commissions to sell the 240 call now, and repurchase it later.  That, plus the premium you pay to buy the 240 call can easily be more than the $20 you collected.

Fourth, spreads are more difficult to trade than single options and the fact that you must sell the spread to collect your profit (later) is going to make it more difficult.  It will be much easier to simply sell the 230 call when you are ready to do that.

Thus, for this specific example – forget the spread and just buy the 230 call.

2) Yes, $232.50 is the break-even price –
but that only counts when expiration arrives. 

The spread will be trading at a price that is higher or lower than $2.50 at various times during its lifetime.  There is no need to wait for the options to expire, and in fact, most of the time you
will want to close the trade prior to expiration.

You are looking for a method that tells you at which stock price the spread is going to be profitable.

3) There is no simple, yet satisfactory, method for determining the stock price at which your spread will be at, or above, the break-even point.  [The best you can do is to use a calculator, such as the one offered by the CBOE and then calculate each option in the spread (or the single option if you don't use the spread)]

Why?

The price of the options in the spread depend on much more than the stock price.  Two critical factors that are 100% independent of stock price are:


Time remaining:  The time premium in each option determines the value of the option (Value = intrinsic value, if any, plus time value).  With little time remaining, the 240 call may be almost worthless but the value of the 230 call depends on more than the stock price.

For example, with 3 weeks remaining, and assuming the stock is 225 and the implied volatility is 25, the options are worth $3.30 and $1.00.  Thus, the spread is worth $2.30.

Two weeks later, the options would be worth $1.30 and $0.10

However, if the stock is 230, the three-week values are: $5.50 and $2.00.  The one week values are: $3.15 and $0.45

Time is such an important factor, that you cannot simply use the stock price to determine the break-even point.


Implied volatility (IV): Unless there is very little time remaining before the options expire, one of the major factors in determining the price of the option is its implied volatility.

For example, assume your stock is trading at $232 one week prior to expiration.

if IV is 20, the 230 call is worth $320

If IV is 40, the 230 call is worth $620

That means there is no simple method for determining your break-even price.  It depends on too many factors.  You would have to use a calculator or simply watch your options in the market place.

As an aside to you, I'm not a believer in considering the break-even point.  I know that is absurd to many, but I truly believe that the best method for managing risk for a given trade is to think about the trade as it is at any point in time. 

Then decide: Do you want to own this position, today, at this price?  Is the risk/reward profile attractive?  If you have a market opinion, you would have to take that into consideration and determine whether this is a good position NOW, or if you would be better off exiting the trade. 

It's a profit or it's a loss.  To me it does not matter (at the time the decision is made).  It matters later for anyone who keeps good records, but the risk of a position is independent of its profitability.

Final note:  It is not necessary to buy options at the ask price nor sell them at the bid price.  You can do better by entering limit orders.

550



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