Friday, October 26, 2012

Options 2.0 – Part 9. Long Call Spread


Options strategies with two legs
Today we’re going to make a start on option strategies with two legs: two options cleverly combined to optimally tune the Risks and Rewards. And we’ll highlight all of the pros and cons.

We’re going to combine two options, to create option strategies with two legs, such as:

Today I’m going to outline the first option strategy with two legs: the Long Call Spread.

Long Call Spread
Structure
The Long Call Spread consists of two legs; the Purchase of a Call option and the Sale of a Call option with the same expiration date and a higher strike price.

Application
A Long Call Spread is useful if you anticipate a (small) increase in the price of the underlying asset.
A Long Call Spread can be used in three different ways:
  • Defensive; both strike prices in-the-money;
    • The market price must fall to the highest strike price for maximum profit
  • Offensive; lowest exercise price in-the-money, highest strike price out-of-the-money;
    • A consistent market price results in profit upon expiration
    • A market price increase equal to the highest strike price is required for maximum profit
  • Aggressive; both strike prices out-of-the-money;
    • A consistent market price results in maximum loss
    • The market price must increase to the lowest strike price + the price of the Long Call Spread for a break-even result
    • The market price must increase to the highest exercise price for maximum profit

Investment
The investment amounts to the number of contracts that you trade x the contract size x the price of the Long Call Spread (= price of the purchased Call minus the price of the sold Call option). If you buy 10 Call options for 10.25 and sell 10 Call options for 6.65 then you pay a balance of 10 * 100 * (10.25 - 6.65) = 1.000 * 3.60 = 3,600 euros.

Margin
The Long Call Spread strategy has no margin obligation.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price of the purchased Call option + the price that you paid for the Long Call Spread.

Maximum Profit
The maximum profit in a Long Call Spread is limited. Upon expiration, the maximum profit is equal to the strike price of the sold Call option minus the exercise price of the purchased Call option, minus the price you paid for the Long Call Spread.

Maximum Loss
Your maximum loss is equal to your investment. If the price of the underlying asset is equal to or less than the strike price of the purchased Call option upon maturity, then no intrinsic value remains for either Call option. The Call options expire at 0 and you lose your investment.

Advantages
The advantage of the Long Call Spread is that a small investment can achieve high returns at consistent market prices and / or small price increases.

Disadvantages
The disadvantage of the Long Call Spread is that if it expires at a price that is less than the lowest strike price then you’ll lose the entire investment.

Example (based on closing prices of Friday, 19th Oct.):
Suppose we buy a Call option on the AEX-index with a maturity of one month and a strike price of 330.00 for a price of EUR 6.65. And we sell a Call option on the AEX-index with the same expiration date and a higher strike price of 335.00 for a price of EUR 3.85. The AEX lists it at 334.17 at that particular moment in time.
The Long Call Spread has an intrinsic value of 4.17 (= 334.17 - 330.00).
This Long Call Spread costs 2.80 (=6.65 – 3.85).
One Long Call Spread requires an investment of EUR 280 (= 1 x 100 x (6.65 - 3.85) = 100 x 2.80).
With this Long Call Spread you sell for a balance of 4.17 - 2.80 = 1.37 time value. This is accrued as the duration decreases.
At a consistent market price you can achieve a profit of 1.37 (= 49%).
The AEX price must fall to 1.37 (from 334.17 to 332.80 = -0.4%) in order to break even.
Above 332.80 and you’ll realise a profit using this strategy.
And above 335.00 (0.25%) upon expiration, then you’ll realise the maximum profit using this strategy. The maximum profit is 335.00 - 330.00 - 2.80 = 5.00 - 2.80 = 2.20 at an investment of 2.80 (= 78%).

Upon expiration your results are as follows:

Long Call Spread Graphical Simulation:

Pitfalls
The traditional pitfall for private investors using Long Call Spreads is to purchase "aggressive" out-of-the-money Call Spreads, in the hope that the price of the underlying asset rises sufficiently with time. The potential maximum yield is extremely high, however, the investor may lose sight of the fact that if the price remains constant then the entire investment evaporates.

Consider investing in offensive or defensive Long Call Spreads instead, which may offer less in terms of maximum profit, but result in a much smaller loss (or gain) at a consistent underlying asset price.

Please refer to the above table for sample calculations (upon expiration) of various Long Call Spreads on the AEX with a maturity of one month:
  • For an aggressive Long Call Spread 340-345, the AEX must rise by 3.2% to 345 upon expiration for a maximum profit of 355%. If the AEX lists less than 340 (+1.7%) upon expiration the loss will be 100%. Break-even is reached at an AEX of 341.10 (+2.1%).
  • For an offensive Long Call Spread 330-335, the AEX must rise by 0.2% to 335 upon expiration for a maximum profit of 79%. If the AEX lists less than 330 (-1.2%) upon expiration then the loss will be 100%. Break-even is reached at an AEX of 332.80 (-0.4%).
  • For a defensive Long Call Spread 320-325, the AEX must fall by 2.7% to 325 upon expiration for a maximum profit of 23%. If the AEX lists less than 320 (-4.2%) upon expiration then the loss will be 100%. Break-even is reached at an AEX of 324.05 (-3.0%).

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.