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Option Spreads


A Minyan asks for an opinion:

"I currently have a QQQ bear call spread: I am long 5 of the April 36 calls and short 5 of the April 32 calls. The position is currently profitable based on market prices. I have not traded the position since putting it on.

If I consider the market to be oversold, what, if any, of the following actions should I take:

1. Close the 32 short position => get some gains, on the
other side, keep the 36 long as it is near the money and 60% loss
2. Roll-down the position to 35/31 May or June (sell the May 31 call
and buy the May 35 call).

In other words, "what basic questions shall I ask myself before
considering one of these moves" ?

First of all, let's see where you are at. The QQQ index is currently at 35.77:

Price Delta Intrinsic
April 32 call 3.95 -.9 3.77
April 36 call .95 .5 0
3.00 -.4 3.77

The maximum value at expiration for your position is zero (since you sold it and collected the premium) and occurs with the index closing below 32. The maximum loss for your position is 4 (36-32) and occurs with the index closing above 36.

The problem with any spread is that this full value will not be reached until expiration because the options hold time premium. The index would have to drop significantly below 32 for the value to approach zero before expiration.

Currently the value of the spread (what we call marked to market) is 3; if you do nothing and the QQQ index closes here at 35.77, the spread will be worth 3.77 (see intrinsic value) and you will lose .77 from today's mark. The net delta of -.4 indicates that if the index rises by 1, the spread will lose .4 in value (today or tomorrow).

My first point is that when entering into a spread, because the index can move a fair amount without moving the spread that much (because options retain time premium), spreads are not the best way to either time the market or profit from being correct on directional moves (at least not initially).

When entering a spread trade first look for a clear advantage on price (the skew can work in your favor) and second, acknowledge that you trade off being right over the long run (at a lower cost) with being immediately right. When initiating the spread in the first place, your line of reasoning should be something like this, " I think the QQQ is going to drop to around 31 by April expiration, but I am not sure how or when ; in fact, I think the most logical scenario is that it just grinds down slowly to that level. I also see the 32 strike calls (or puts) as relatively expensive to the 36 strike."

By entering a spread trade you implicitly are betting that the index will be at a certain level "at" a certain time. Because this is a low probability, you don't have to spend as much money as you would with an outright long option.

Your first choice, buying back your short call, is fairly aggressive and is essentially putting a new trade on. It goes against your main premise, which is that the market is going down. If you are wrong and buy back your short call for 3.95, you then have a high probability (around 50%) of losing .95 from there. It is not a bad choice, just different and one with about a 50% chance of being wrong. An alternative would be to buy back 3 out of five of your short calls for 3.95; in this way if the market declined you would not be out the premium of your long 36 calls.

Your second choice is a good one if it were not for the friction costs involved: paying market spreads and commissions. By doing this trade you reduce your short delta from -.4 to -.25, so you better position yourself for a rally, but this is only in the near term and the costs associated with it make it unattractive.

I rarely make directional bets and when I do I do not use spreads. I trade spreads to buy cheap options and sell rich ones.

The bottom line is it is a personal choice. The best thing to do is map out what you can make and what you can lose and tailor that to your expectations.

But I learned a long time ago that what I expect and what actually happens are two entirely different things.

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