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Option purchases and Vertical Debit Spreads – The strategies, and converting to “Free Trades”.
In this paper, we'll discuss the option purchase and vertical debit spread strategies, and ways to convert those positions to “Free Trades” under favorable market conditions.
Option purchases.
For many traders, the first introduction to the world of options is the simple concept of buying a call or put. Depending on the market opinion, traders will buy a call to benefit from a rise in the underlying market, or buy a put to benefit from a decline (not considering effects of time decay or changes in implied volatility). If your conviction about market direction is strong, you might be purchasing in-the-money options, which will have a high "delta", and gain a high percentage of what the underlying futures would gain. To take a lighter position, out-of-the-money options might be used which will have a lower delta, and less risk if the market doesn't go your way. And in the right situation when you think a good move could be forthcoming, but you're uncertain about direction, and implied volatility is cheap, you can buy both puts and calls by purchasing long straddles (same strike options) or strangles (different strikes).
When used properly, simple "premium purchasing", or buying options, can be a very effective strategy with absolutely defined risk. In fact, in certain market conditions, when the relationship of implied volatility and potential market movement is combined, the "simple" strategy of buying an option may be absolutely the best strategy when viewing reward/risk scenarios, after more complex strategies have been evaluated. In one sense, coming to the conclusion that a simple call or put purchase is the best strategy takes just as much research and analysis as deciding on a more complex strategy involving multiple positions and combinations of long and short premium. If used correctly with a good trading plan and risk control, long options can be very profitable, and certainly aren't the "fool’s game" that they are often said to be. In fact, the combination of limited risk, unlimited reward, and very high leverage makes them very attractive in certain market conditions.
When you are simply long an option, and the market goes your way, you can turn this into one type of a "Free Trade" by selling another further out-of-the-money option against your original long position. If more than the original premium is collected by selling the new option, you can lock in a profit, while leaving additional potential. If desired, this return of capital can be used to build a larger position on a pullback, or you can trade in and out of the short option if you want to take advantage of market swings.
Converting an option purchase to a “Free Trade”.
When the trader is has a long option (call or put), and the market moves favorably, it can often be converted to a Free Trade by adjusting the trade into a vertical spread.
For an example (hypothetical) of the simple option purchase and Free Trade, let's say July soybeans are trading at $6.00 a bushel. It's three months from July option expiration, implied volatility is about in the middle of its historical range, and the at-the-money 600 call is trading at about 22 cents ($1100). The in-the-money 550 call is trading at about 55 cents (having mostly intrinsic value and little time premium), and the out-of-the-money 650 call is trading at about 8 cents. So you purchase the 600 call, and then beans rally up to 650 in two weeks. You think beans may be near a resistance area and might stall or pull back, and you want to take some money off the table. In the two weeks during the rally, there has been some time decay against your long call, but the rise in implied volatility (typical in grain options during large rallies) would probably compensate for it during this short of a time period. So now, with July beans trading at 650, the 650 call is trading at about 22 cents, the same as the price you paid for your original 600 call. If you now sell the 650 call (and hold your original long 600 call), you will have gotten back all the original money you spent, and you're now holding a 600-650 vertical call spread (to you it's a Free Trade). The long spread you're holding would now be worth about 33 cents ($1650), your paper profit at this point in time, just about the same as if you had just sold your original long call and exited the trade. By turning your original long call into a Free Trade, you've eliminated all risk from the original position, while leaving yourself a $2500 profit potential if beans close at or above 650 at option expiration. The original long 600 call would only make 28 cents profit with beans at 650 at expiration, because you have to deduct its original cost (22 cents) from its intrinsic value at option expiration. The trade-off here is that if beans moved to much higher prices, you would have limited your profit. However, if you again thought that prices were going higher after you had turned the original long call into a spread, you can still add to your position by using the capital that you retrieved to buy another call. In other words, you add to your position and profit potential while not committing any more than the original capital. The right thing to do is going to depend on the market dynamics at that time.
The vertical debit spread.
This is often the next strategy that option traders will learn about. It simply combines the purchase of a long call with the sale of another call (or vice- versa for puts), both having the same expiration date. In a debit spread, the long option will cost more than the short, so the trade will incur a cost at entry. Like the simple call or put purchase, long call debit spreads are bullish and will gain if the market rallies, and the put debit spreads are bearish and will gain if the market declines. Again, this is assuming little effect from time decay or implied volatility changes. One of the trade-offs between a long option spread and a plain long option is that the spread will have limited profit potential. At option expiration, the maximum value for the spread is achieved if the market is at or beyond the short option strike price, and the spread is "filled". Like long options, long spreads have limited risk, and have no margin beyond the original premium cost.
Debit spreads are often used in situations where implied option volatility is fairly high, but you still want to take a limited-risk directional position. By selling another option against your long, you can eliminate much of the effect of this expensive volatility, although it still matters. Also, if at least the long option of a vertical spread is in-the-money to start with, the trade can even have positive "time decay", if the market just stays at the same price. This is an advantage that you can't have with a simple long option.
Markets with high option volatility also often have "skewing" in volatility, meaning that the option you are selling has even higher implied volatility than the option you are purchasing, giving you an immediate advantage. This can often be quite dramatic in some markets during times of extreme "emotion" and speculation. Even when at-the-money option premium becomes very expensive, the out-of-the-money options can go to astronomical levels of implied volatility, getting pumped up to absurd, unsustainable levels by traders consumed by greed or fear. An example of greed driving call premiums to high levels is found in soybeans or coffee during big bull moves. Conversely, fear is the driving force behind put premiums being bid up dramatically in the stock market during severe market declines.
Converting a vertical debit spread to a “Free Trade”.
We’ll discuss two "adjustments" for vertical spreads that can be used to convert them to Free Trades. The choice of which adjustment to use depends on the market outlook.
Adjusting the vertical debit spread to a Free Trade (or recover premium) by "rolling" one of the options. After the original vertical option spread is initiated, if the market moves in your favor, you may choose to make an adjustment and reduce the width of the spread. This "trick of the trade" can be used to collect premium, either reducing the overall trade cost, or even collecting enough to lock in a profit while leaving more profit potential. It doesn't matter whether the spread was put on as an original position at a debit, or the result of Free-Trading a long option that was converted to a spread. This adjustment involves "rolling" either the long or the short option in the spread, reducing the distance between the strikes.
As a general rule, this is usually best for trades that start with original spreads that are three strikes apart or wider. Just like Free Trading a long call, the trade-off here (there's always a trade-off) is that it will reduce the profit potential. A slight variation of this strategy involves initiating another "credit spread" outside of the original spread, turning the trade into a "butterfly" or "condor" position, two other positions with defined risk.
Let's use a long vertical put spread as an example. We’ll review a case history in the Japanese Yen. From mid-January until mid-February, 1999, there were opportunities to buy the June Japanese Yen 84-80 vertical debit spread (long the June 84 put/ short the 80 put), at a debit of about 80 points ($1000). The June Yen was then trading at about the 8900 to 9100 level. After some time, the market declined, and traders had the opportunity to reduce the original premium costs. This could have been accomplished by "rolling up" the short 80 put to an 82 put at a credit of 50 points or more, significantly reducing the original capital invested, while still leaving an 84-82 put spread in place that would have $2500 potential value at option expiration if the June Yen closed below 8200. By mid-February, with the June Yen at 8550, this "adjustment" was already at 57 ticks, and got higher as the Yen moved lower. More premium could have been collected by "rolling down" the long call, but the idea was to keep the long call at a higher strike, thus giving it more of a chance of being in-the-money at option expiration. Incidentally, at the early March lows, the credit for rolling up the short put settled at 85 points, so in an "idealized" history of the trade, it could have been Free Traded using the credit spread adjustment strategy. Anyway, let's say that you took that trade at the original 80 point debit, and then brought back just 50 points on the adjustment. You would now be long the 84-82 put spread at a cost of 30 points or less, and the spread should have reached full value (200 points, $2500)) when options expired at the end of the first week of June.
Reversing a long debit spread to a credit spread position. You might consider this strategy if your market outlook has gone from directional to neutral, or actually reversed. This strategy would normally be used when you've been in a spread that has gone your way, but now you think that the market will stop, consolidate, or reverse long enough to get to option expiration. It involves turning your long spread into a short spread, or what would be known as a credit spread. This is done by selling the long option, and bringing in a credit by "rolling it out" beyond the strike of the short option from the original spread. You are now in a credit spread that has a limited risk (the value between the two strikes), but only if the market keeps going in the previous direction. If the market stops or reverses as you think, the credit spread that you have rolled into will expire worthless. This strategy can be a very useful tool in the right situation.
The simplest way to see this is that when you put on your original vertical "debit spread" that cost you money, another trader was putting on a "credit spread" that brought in premium. Just as your debit spread has the risk limited to the premium cost, the credit spread has risk limited to the value of the difference between the strikes. Using the example of the Yen above, your risk in going "long" the 84-80 June Yen put spread was 80 points, but the risk for the person on the other side of the trade is 320 points (400 points spread value, minus 80 points credit received). However, a trader in either position would normally only risk a percent of total risk, and a commercial producer or market-maker would usually be hedged to delta neutral with product or futures contracts.
We’ll continue to use the example of the Yen put spread. Let's say you were in the original June Yen 84-80 put spread, initiated at 80 points debit. After the June Yen started to decline, it was down to 8379 on April 1, so the long put is just slightly in the money. The spread is at 148 points, showing a 68-point profit. Now, if you thought the market was going to stabilize, or not go much lower, the long spread would stand to lose quite a bit by option expiration, since it only has 21 points of intrinsic value (the 84 put is 21 points in the money). Of course you could just take the profits, 68 points (no slippage considered). Or, you could sell our long 84 put (settled at 238 points), and buy the 78 put, last settled at 53 points, to bring in a credit of 185 points, or 37 points more ($463) than what you could have taken out of the long spread. The drawback (there's the trade-off again), is that you are now subject to the risk in the short spread (short the 80 put/ long the 78), which has a value of $2500 between the strikes. Since the profit in the whole trade after making the adjustment was 105 points (185-80), you are now at risk 95 points (200 points spread value minus the 105 point profit). However, the point here is that you would never do this without the conviction that the short spread was not going to go in the money, and if you feel that way, this gives you a way get some more premium out of your position. In this case, the Yen did start to rebound after making lows in May, and was near 8200 at option expiration, ideal for a position that had been converted to a credit spread, as discussed. So, this was actually like combining the action of one trader who decides to take profits on a long put spread with another trader who decides to do a new out-of-the-money credit spread; in this case it's done by the same person because the market outlook has changed.
