What effect does widening the spread from one to two points on a vertical credit spread have? The following article takes a look at this scenario or see. You may be surprised by the results. I know I was.
In this post, we will examine a couple of option trading cases that only use $200 seed capital. Both option strategies will be done on the same underlying and with the same type of vertical credit spread. The only variation will be the width of the spreads. Going through this type of comparison is a practical way to help the novice trader begin to see some of the many nuances that make up option trading.
PART I: A Single Point Wide Short Vertical
As an example, we are going to select a Bullish vertical spread on the exchange traded fund that tracks the Russell 2000. Due to the fact that we are considering being a premium seller of monthly options, on Friday afternoon (9/30/2011) just before the closing bell, we should base our trading decisions off the monthly chart. On the lower chart studies, we will pull up the Average True Range indicator. In our case, at the time, the monthly ATR was 7.35 which means that in any given month, IWM is likely to move either up or down approximately that amount. With IWM trading at 64.18, we can select a strike price 8 points lower, or at 56 to be exact. In that case, the distance between 64.18 and 56 is greater than 8 points (8.18 to be exact) which is well outside of the monthly ATR range of 7.35. The premium pricing of the Oct 56 put (8.18 cents away from the current IWM price) was quoted at the Bid for 0.85. We also had to buy the 55 put for protection at 0.71 (as the midpoint between the bid and ask), leaving us with a difference of 0.14, the total credit received. The sale of the 56 put is outside the range of the natural monthly “breathing” of the IWM.
Figure 1
The 56/55 spread specifics are listed below:
Vertical 56/55 Credit spread (Bull Put) on IWM 64.18
Monthly ATR = 7.35 and our cushion is 64.18 – 56 = 8.18
Cushion versus the monthly ATR: 8.18 > 7.35
This could be considered a conservative trade.
STO – 1 Oct [0.12 delta] 56 put @ 0.85
BTO + 1 Oct 55 put @ 0.71
Max Profit (0.85-0.71) = 0.14
Max Loss (56p – 55p) spread-width minus the credit
Max Loss = 1.00 – 0.14 = 0.86
ROR = 0.14/0.86 = 16%
In short, for this first example, we are risking close to one hundred dollars per single contract and are able to make 16%, yet if we were to invest two hundred dollars and the trade worked out, then we would make twice as much on 2 contracts, or 0.32 to be exact.
PART II: A Two Point Wide Short Vertical
Let us now turn our attention to the same Bull Put strategy except we will make the spread two points wide instead of one. The 56/54 spread specifics are listed below:
Vertical 56/54 Credit spread (Bull Put) on IWM 64.18
Monthly ATR = 7.35 and our cushion is 64.18 – 56 = 8.18
Cushion versus the monthly ATR: 8.18 > 7.35
This could be considered a conservative trade.
STO – 1 Oct [0.12 delta] 56 put @ 0.85
BTO + 1 Oct (two points strike spread) 54 put @ 0.58 (midpoint between Bid and Ask)
Max Profit (0.85 – 0.58) = 0.27
Max Loss (56p – 54p) spread-width minus the credit
Max P = (2.00 – 0.27) = 1.73
ROR = 0.27/1.73 = 16%
What is interesting to observe is that the cost of doing this trade involves $200, and our profit does not go up at all. All things being equal, the sold 56 contract has the same possibility of being touched, so both trades, in terms of risk, are nearly identical.
In conclusion, the widening of a spread from a single point strike increment to two points is really the functionality of the risk of the sold strike price rather than anything else. Knowing your options before you trade them is so essential.
See The Options Insider for entire lesson
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