The Vertical Spread
Past articles have illustrated how to use graphs to design option strategies. Here I will go over some details of one broker's strategy recommendation to its derivative customers, a recommendation the broker says will hedge current market exposure (provide downside protection) and take advantage of option pricing. You can decide for yourself if the recommendation is sound.
The strategy consists of buying one SPX September 950 put at $18.50 and selling two SPX September 925 puts at $13. This is called a vertical spread (or ratio vertical) and is depicted in the following graph:
Total Return Graph: Long one SPX 9/950 put at $18.50 and short two 9/925 puts at $13
The red dotted line depicts buying one 950 put; the dotted blue line depicts selling two 925 puts. Remember how to combine these positions to create the solid black line. Try to calculate the breakeven points.
The 950 put purchased at $18.50 per contract equates to an implied volatility of 20.6% while the 925 puts sold equates to a 21.6%. So is selling puts that are 2.5% further out of the money (25/950) when the long 950 puts are at the money for one more volatility point a good trade? Maybe, but I will tell you that just six months ago you could have sold them higher by at least one more volatility point. The vega on the 925 puts is $1.45; instead of getting $13 we could have gotten $14.45 in a less complacent market. How would this change the breakevens?
As far as the strategy providing a hedge or downside protection just look at the graph. It seems to for a while, but then the strategy actually begins to lose money below 892.5, a level the market has traded at quite often over the last six months. In addition, I will tell you that if the market trades down to about 925, this spread will not make that much money until fairly close to expiration (deep in the money or way out of the money options lose their time premium rapidly, but at the money options retain much their time premium until close to expiration), so you have to wait and hope that the market is still there at expiration.
Understand what environment (volatile or not) the market is in when deciding not only on strategy, but on the price. Because options use leverage, an option trader must be very intelligent (and stubborn) about price. Sometimes the best trade is no trade at all.
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