For the sake of simplicity, the examples below do not take transaction costs (commissions and other fees) into account. Transaction costs for trades placed online are $9.99 for stock orders, $9.99 for option orders plus a $0.75 fee per contract. Option exercises and assignments incur a $19.99 fee.
Many options traders are discovering wider uses of options and one of the first things they’re drawn to is leverage. Some investors start by buying options outright and are immediately frustrated by theta (time decay). They often think there has to be a way to offset some of this time decay and yet, reflect the position they would like in this stock. This thought process brings many of them to the long vertical spread.
Let’s use Apple (AAPL) as our test subject to explore verticals and leverage. Many retail investors like to both trade and hold AAPL. In fact, it was No. 1 in both of those categories at TD Ameritrade during 2014. For that reason (and that reason alone—no recommendation here), let’s take a closer look. One quick caveat: we’re going to use the premise that you are looking to go long AAPL and expect it to go higher, so we’ll use a long call vertical spread in order to teach this. Keep in mind, you can use this logic if you believe a stock is headed lower and purchase a long vertical put spread also.
Let’s review a few basics to get started. First, just like any directional trade, we’ve established a premise in which we believe the stock is going higher. It’s currently trading in our example in figure 1 at 117.43. Now that we have that established and because we are options traders, we’re naturally drawn to buying a call. In our AAPL example, first focus on the option we’re purchasing; here, that’s the March 110 call. There are a number of reasons we might purchase an in the money, rather than an out of the money, call and we’ll cover that shortly. We could then sell the March 130 call against our purchase. In our example, the vertical spread of purchasing the March 110 and selling the March 130 call spread has a theoretical value of $8.15 (as standard options are based on 100 shares the real dollar amount is then $815. We derive this price by taking the March 110 call theoretical price of $8.95 and subtracting the March 130 call theoretical price of $0.80. This spread, purchased for $8.15, has the potential (although no guarantee) to go to $20.00 for a profit of $11.85. Now, consider the risk. Our loss potential is what we paid for the spread, or the full $8.15.
About That Tick-Tock
Now, back to time decay. One of the beautiful things about using options contracts that are equidistant from the money is their time decay will be very similar. That means you’re not just watching premium melt away. Keep in mind we purchased a call that has theoretical (intrinsic) value. We know that with AAPL trading at $117.43 in our example screen shot that the 110 strike call has an intrinsic value of $7.43. We sold a call that has zero intrinsic value; actually, the 130 call has only extrinsic value of $0.80.
Quick side bar: How do I know if I’m looking at intrinsic or extrinsic? Ask yourself if you would buy that call and it makes sense in a zero-premium world to exercise that call. If so, it has intrinsic value. I think any of us would be happy to exercise the right to buy AAPL at $110 per share when it is trading $117. Conversely, who would want to buy AAPL at $130 when it is trading at $117.43?
Back to our example. We see that the 110-130 call spread has an intrinsic value of $7.43 and we paid $8.15. That gives us a true sense of the premium we are paying: $0.62.
Consider the Risk
The risk in our example is we could lose our entire $8.15 if the price of AAPL drops to 110 or lower and both options expire worthless. That’s pretty straight forward. But there’s a little more to consider. Since we sold the 130 call, someone may exercise it if the price of AAPL rises to 130 or higher prior to expiration. If this happens, we would be required to sell 100 shares of AAPL that we don’t own, resulting in a short stock position. But since we are long the 110 call, we can exercise that contract, flattening the short stock position, resulting in a profit of $11.85 per share. It’s important to note that these assignment and exercise events trigger additional transaction costs which can have a significant impact any potential returns. So if both sides are exercised/assigned, the spread went to max profit minus any related commissions and fees.
Now, keep in mind that on the other side of this scenario, the maximum profit is achieved by the stock going to $130 or higher by expiration. Remember, you make a compromise whenever you spread a trade. Because we offset the cost of the purchase of the 110 call by selling the 130 call, we have now capped our upside for the stock at $130. Let’s be honest. If we go from $117.43 up to $130 prior to or at March expiration (50 calendar days from my writing), we will have a spread that goes from $8.15 to $20.00. I would qualify that as a good outcome.
One last point to keep in mind. This trade is more about the 110 call. The 130 call is in place to provide cost reduction and theta offset. I believe that when you go into a trade with that mind set, it really helps you realize the range of potential outcomes, what you want to achieve, and can help you visualize a strike you want to buy and a strike you want to sell.
Next time, we’ll stay vertical but we’ll talk about selling high-probability vertical spreads.