Bear Call Spread: Strategy Risks

Posted on March 10th, 2010 admin No Comments

It is important to always be aware of the strategy risks. The primary risk when placing a bear call spread is when the share price increases past the sold call option and an ever greater concern is if the share price increases above the bought call option (protection). Since you receive a premium to enter this trade there is a required margin. This margin can increase to as much as 1.2 times your maximum loss. For example if you were risk $5,000 the cash margin required in the account can increase to $6,000 (5000 *1.2) which includes the premium received. So it is important to know your maximum risk and make sure there are enough funds to cover the worst case scenario.

Another risk inherent with selling options is volatility. When you open the bear call spread you want the volatility to be high so you can sell the call options for as much value as possible. Once the trade is placed you want the volatility to drop off and time decay to kick in. So even if the share price stays still but volatility increases the position may not profit in the short-term. Increased levels in volatility mean to close out it will cost more to buy back the sold call option. If the share price increase above the sold put option prior to expiry there is potentially a risk of exercise.

Exercise

The main risk of credit spreads is the risk of being exercised. If the sold call option is exercised it means that you are obligated to sell shares at the exercise price of the sold call option. This can have a negative impact in terms of you have sold shares you do not own which means you need to buy them back at the higher level and therefore locking in a loss on that position. If the share price is above the bought call option (protection) when exercised then you can sell the call option which will reduce the loss from being exercised. It is still not possible to lose more than the maximum risk before entering the trade. Another disadvantage of being exercised is the brokerage on the share sale and purchase so it is a good idea to try an avoid exercise. To avoid being exercised you need to monitor your position and more importantly the delta of the sold call option. If the share price is above the sold call option an indication of the likelihood of being exercised can be identified by the delta. If the delta on the sold call option is above 0.95 there is a chance being exercised. If the delta is above 0.98 then it is necessary to implement one of your exit strategies.

To avoid exercise there are two options. If you think the share price will keep increasing you can close the trade for a loss. If you think you view is correct and the share price will fall from this level and want to keep the position you can roll out to the next month. What this means is you can close the positions you have an open the same position for the next month and do this for no cost or a small credit. Therefore if the share price then decreases below the sold call by the next month you can still make maximum profit. This options is normally recommended unless your analysis, technical or fundamentals, indicate a change is trend or market conditions.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Identifying Trades – The Greeks

Posted on March 9th, 2010 admin No Comments

Delta

When identifying trades it is essential to look at the delta of the option legs. In particular it is important to calculate the net delta of the bear call spread. The net delta is calculated by the delta of the bought call option minus the delta of the sold call option. The net delta will always be positive. The net delta indicates if the share price decreases quickly what the value of the bear call spread will be worth. For example, if a bear call spread had a net delta of 0.20, and the share price decreased by $1.00, the bear call spread would have decreased by 20 cents.

Vega

The volatility affect on a bear call spread is varied. When looking to enter a bear call spread you look to sell an out-of-the-money call option. The idea is to sell a call which has a relatively high volatility and therefore trading above its theoretical value. The bear call spread can be traded when volatility is high on the call option which allows the spread to be higher above the current share price so the stock would have to increase further before affecting the trade.

Theta

Credit spreads are trades that take advantage of the time decay nature of options. The effect or time decay is a positive for this trade. When the share price is below the sold call if the share price and volatility remain constant this value of the position will reduce and therefore increase your profit. If the stock price is closer to the lower strike price of the sold call, profits generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the bought call, profits generally decrease at a faster rate as time passes.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Option Pay-Off Diagram

Posted on March 9th, 2010 admin No Comments

It is essential to understand the option pay-off diagram for the option strategy you are trading. It allows you to know to determine at what share price you achieve maximum profit, maximum loss and breakeven level at expiry. The bear call spread is made up of a sold call option and a bought call option at a higher strike. When combined it creates a bear call spread. See below for how the bear call option pay-off diagram is constructed. The dotted green line is the sold call and the dashed green line represents the bought call.

Sold Call


Bought Call


Bear Call Spread


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Bear Call Spread: The Psychology

Posted on March 9th, 2010 admin No Comments

The reasoning behind placing a credit spread is different to placing a debit spread. Bear Call Spreads and Bull Put Spreads are credit spreads. They are not as aggressive cause you do not need the share price to move to far in a certain direction for instance a bear call spread profits if the share price goes sideways or fall whereas the bear put spread requires the share price to fall to a certain level for maximum profit. This strategy profits from time decay.

The expected share price movement is neutral to slightly bearish. Selling a call option out-of-the-money you receive premium if the share price is below the sold call option strike price at expiry the premium received is the profit. The bear call spread just means you buy a call at a higher level then you sold the call to cap your risk and indentify you maximum risk rather than having no protection and potentially unlimited risk for a small percentage credit. The reasons for trading bear call spreads are;

  • Alternative to naked calls (selling calls with no protection) as you have a predefined profit and loss and a better risk vs. reward ratio.
  • Share price outlook may be neutral to slight bearish on the share price due to a resistance level.
  • Consider the bear call spread when you are expecting a small fall in the price of the stock.
  • The trade of with placing a bear call far out of the money is that the stock price can increase in share price slightly, stay flat or fall to make a profit. So even if you are wrong you can still profit from the trade.
  • This strategy can be used to produce income.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bear Call Spread: Advantages and Disadvantages

Posted on March 8th, 2010 admin No Comments

Advantages of Bear Call Spread

  • Loss is limited if the underlying financial instrument rises instead of falls.
  • If the underlying instrument fails to drop below the strike price of the out-of-the -money sold call option, the profit yield will be greater than just buying put options.
  • Able to profit even when the underlying asset remains completely still.
  • Lower risk than simply writing naked call options as maximum downside is limited by the bought call option.

Disadvantages of Bear Call Spread

  • There will be no more profits possible if the share price drops beyond the strike price of the sold call option.
  • Because it is a credit spread, there is a margin requirement in order to put on the position.
  • As long as the short call options remain in-the-money, there is a possibility of it being assigned. You may then have to purchase the underlying stock to meet the sold call obligation.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 1300 368 316 or info@totaloptions.com.au

Bull Call Spread: Strategy Risk

Posted on February 26th, 2010 admin No Comments

It is important to always be aware of the strategy risks. The main risk to be aware when trading bull call spreads is there is a potential to lose all of money invested. Time decay is a risk if the share price stays still as the sold call option does not totally eliminate the risk of time decay. Also if the share price move happens too quickly the bull call spread may only have a small profit because the volatility would have increased in the out-of-the-money option, meaning it would be expensive to buy back to close out the trade.


To receive ASX Option Recommendations or to learn more about Bull Call Spread, Bull Put Spread, Bear Call Spread, Bear Put Spread Strategies please request the Option Spreads eBook by contacting us on 07 5504 2244 or info@totaloptions.com.au

Bull Call Spread: Options Pay-Off Diagrams

Posted on February 25th, 2010 admin No Comments

It is essential to understand the option pay-off diagram for the option strategy you are trading. It allows you to know to determine at what share price you achieve maximum profit, maximum loss and break even level at expiry. The bull call spread is made up of a bought call option and a sold call option at a higher strike. When combined it creates a bull call spread. See below for how the bull call option pay-off diagram is constructed. The dotted green line is the sold call and the dashed green line represents the bought call

Bought Call

 

 

 

Sold Call

 

 

 

Bull Call Spread

 

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Bull Call Spread: Advantages and Disadvantages

Posted on February 24th, 2010 admin No Comments

Advantages of Bull Call Spread

  • The loss is limited to initial investment.
  • If the share price fails to rise beyond the strike price of the out-of-the-money sold call option, the profit yield will be greater than just buying call options.
  • It is also a way of buying call options at a discount by selling the out-of-the-money call option at a strike price beyond that which the share price is expected to rise.

Disadvantages of Bull Call Spread

  • There will be no more profits possible if the share price rises beyond the strike price of the sold out-of-the-money call option.
  • The net delta of the combination is less than just buying a call option so exiting trade early is not as profitable as buying a call.


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Bull Call Spread: The Strategy

Posted on February 23rd, 2010 admin No Comments

A bull call spread is used when a moderate rise in the price of the underlying share is expected. It is achieved by simultaneously purchasing call options at a specific strike price while also selling the same number of calls of the same asset and expiration date but at a higher strike. A bull call spread is also a technique to buy call options at a discount. Because you sell an out-of-the-money call option in this option strategy, it effectively reduces your investment on your bought call options. This reduces upfront payment and therefore the risk of the position.

Maximum Profit

Maximum profit is achieved when the share price is above the sold call at expiry. The maximum profit in this strategy is the difference between the strike prices of the bought and sold options, less the net cost of options.

Maximum Loss

If the stock price decreases below the bought call option at the expiration date, then the investor has a maximum loss of the net debit. The net debit is the premium received for selling the out-of-the-money call option minus the cost associated to purchase the call option.

Break Even

The breakeven is lower with the bull call spread then buying a call option. The breakeven point is the strike price of the bought call plus the net debit paid.


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Selection Criteria – Selling Options

Posted on February 22nd, 2010 admin No Comments

When selling options, there are a number of variables to take into consideration. When you enter a sold call option your outlook needs to be that the share price will stay still or fall. Conversely, when you enter a sold put option your outlook needs to be that the share price will stay still or increase. Your objective is to sell time and you profit from your positions time decay. Also you can sell options when the volatility is high and expected to decrease throughout the trade. Your risk profile will determine whether you sell out-of-the-money calls for lower returns and lower risk at-the-money calls to receive more premiums with higher risk of exercise. Before placing any trade you must make sure there is enough open interest and volume through the options so liquidity is not an issue.


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