Bearish Archives - PeakProfit

Put Backspread

Posted on June 26, 2024June 27, 2024 by admin

Put Backspread overview

Put backspreads have three components: one short put option sold in-the-money above the current stock price and two out-of-the-money long put options purchased at a lower price. The long puts will have the same strike price. All three put options have the same expiration date. Put backspreads may be opened for a debit or a credit, depending on the options contacts’ pricing. However, put backspreads are typically established for a credit. The strategy looks to take advantage of a significant move down in the underlying stock and, if the position is opened for a credit, also has profit potential if the security moves higher.

Put Backspread market outlook

A put backspread is purchased when an investor is bearish and believes the underlying asset’s price will be below the long put strike prices at expiration. The profit potential is unlimited below the long puts. A slight decrease in price is the worst scenario for a put backspread. The risk is limited if the underlying stock price increases significantly. If the put backspread is opened for a credit, the position will profit from an increase in price.

How to set up a Put Backspread

A put backspread consists of selling-to-open (STO) one short put option in-the-money and buying-to-open (BTO) two long puts out-of-the-money below the short put option. The number of contracts must have a ratio where more long puts are purchased than short puts are sold.

For example, 1 short put option would require 2 long put options. If the position is opened for a credit, the maximum loss is realized if the underlying stock price is at the strike price of the long put option at expiration, because the short put would be in-the-money and the long puts would expire worthless. The profit potential is unlimited beyond the long put options.

The debit paid or credit collected at entry will depend on how far in-the-money the short put option is and how far out-of-the-money the long put options are relative to the underlying stock price.

Put Backspread payoff diagram

The payoff diagram for a put backspread opened for a credit is V-shaped, with the right side of the “V” capped at the amount of credit received. The risk is defined at entry, while the profit potential is unlimited to the downside. The maximum loss is the credit received at entry, minus the width of the spread. The max loss is realized if the underlying stock closes right at the strike price of the long put options at expiration. In this scenario, the short put would finish in-the-money, and the long puts would have no intrinsic value.

If the stock price closes above the short put at expiration, all options will expire worthless, and the credit received at entry would be realized as a profit. If the stock price closes below the long puts at expiration, all options would expire in-the-money and need to be closed to avoid exercise and assignment. The intrinsic value of the remaining long put option would remain. The width of the spread between the bull put spread, plus or minus the entry pricing, would equal the net profit.

For example, if a stock is trading at $52, and an investor believes the stock will close below $50 at expiration, a put backspread may be entered by selling-to-open (STO) one $55 put option and buying-to-open (BTO) two $50 put options. If the $55 put option received $5.00 in credit, and the two $50 put options cost $2.00 each, the position would create a $1.00 credit at entry. If the stock is at or above $55 at expiration, all of the puts expire worthless and the $100 initial credit received is realized as a profit. If the underlying stock price is $50 at expiration, the long $50 strike puts would expire worthless, and the short put will cost $5.00 to close. The $5.00 to close, minus the $1.00 initial credit, results in the maximum loss for the position of -$400.

If the stock is below $50 at expiration, the realized profit or loss would be the difference between the stock price and the long put price, multiplied by the number of long put contracts, plus the initial credit received, minus the intrinsic value of the in-the-money short put option. For example, if the stock closed at $48 at expiration, the net loss would be -$200. The short put would be in-the-money $7.00 and the two long puts would be in-the-money $2.00. The long puts would profit $400 ($2.00 ITM x2) + the initial credit of $100 = +$500. But, the short put would need to be closed for -$700.

There are two break-even prices for a put backspread: 1) the strike price of the short put minus the credit received and 2) the strike price of the short put minus two times the difference between the strike prices plus the initial credit. In the example above, the two break-even prices are $46 and $54. If the underlying stock is below the lower break-even price, the profit is unlimited to the downside until the stock reaches $0.

Image of call backspread payoff diagram showing max profit, max loss, and break-even points

Entering a Put Backspread

A put backspread is a bull put credit spread with an additional put purchased at the same strike price as the long put in the spread. All options have the same expiration date.

To enter the position, sell-to-open (STO) a short put option and buy-to-open (BTO) long put options. The ratio of long puts to short puts must be greater than 1:1. Despite the bull put spread, the strategy is bearish. The put backspread has a similar payoff diagram and outlook as a single long put, but with an additional opportunity for profit on the upside when sold for a credit. The bull put spread reduces the price of the additional long put option and decreases the potential risk by bringing in a credit.

Put backspreads may be purchased for a debit or sold for a credit. The price at entry will depend on the width of the spread, how far in-the-money the short put option is, and how far out-of-the-money the long put options are relative to the underlying’s stock price.

Exiting a Put Backspread

A put backspread needs significant movement below the long put strike prices for maximum profit potential. If the underlying stock price is below the long puts at expiration, all three options are in-the-money and must be exited to avoid exercise and assignment. If the stock price is below the short put at expiration, the contract is in-the-money and needs to be closed to avoid assignment.

Profit or loss will depend on the pricing at entry. If the stock price is above the short put option, all contracts will expire worthless, and no action is needed. The credit to enter the position will remain.

Time decay impact on a Put Backspread

Put backspreads are a net long position. Therefore, time decay, or theta, works against the strategy. Every day the time value of an options contract decreases, which will hurt the value of the two long put options.

Implied volatility impact on a Put Backspread

Put backspreads benefit from an increase in the value of implied volatility. Higher implied volatility results in higher option premium prices. Ideally, when a put backspread is opened, implied volatility is lower than where it is at exit or expiration. The strategy relies on the value of the long options to be profitable. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts.

Adjusting a Put Backspread

Put backspreads have a finite amount of time to be profitable. If the put backspread is sold for a credit at entry, and the position’s structure limits risk, put backspreads are typically not adjusted. The primary adjustment for a put backspread would be early profit taking to realize a gain. The position may be rolled up or down if the stock price is not in the profit zone. Put backspreads include at least one short contract. Therefore, assignment is a risk any time before expiration.

External factors may need to be considered when deciding to adjust or close a put backspread position. Suppose an investor wants to avoid assignment risk or extend the trade into the future to allow the strategy more time to become profitable. In that case, the entire position can be closed and reopened at a future expiration date with the same strike prices or new positions.

Rolling a Put Backspread

Put backspreads require the underlying stock price to be below a specific price at expiration. If the position is not profitable, and an investor wishes to extend the trade’s length, the spread may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout may cost money and add risk to the position. The strike prices of the options in a put backspread may also be rolled up or down to reflect any change in price from the underlying asset.

Hedging a Put Backspread

It may be unnecessary to hedge put backspreads because the strategy is a risk-defined position with a clear payoff diagram. The strategy is bearish, and protection from higher movement in the underlying stock is not needed because the bull put spread defines the risk to the upside, and a sharp rise in the underlying security will result in a profit equal to the amount of credit received at entry.

FAQs

What is a put backspread?

A put backspread is a bearish options strategy strategy with defined risk and unlimited profit potential. The strategy looks to take advantage of a significant move down in the underlying stock.

When should I use a put backspread?

You could buy a put backspread is purchased when you’re bearish and believe the underlying asset’s price will be below the long put strike prices at expiration. The profit potential is unlimited below the long puts. A slight decrease in price is the worst scenario for a put backspread. The risk is limited if the underlying stock price increases significantly. If the put backspread is opened for a credit, the position will profit from an increase in price.

What is an example of a put backspread?

To enter a put backspread, sell-to-open (STO) a short put option and buy-to-open (BTO) two long put options. The ratio of long puts to short puts must be greater than 1:1. Although the position’s core is a bull put spread, the strategy is bearish because of the extra long put options.

For example, if a stock is trading at $52, and you believe the stock will close below $50 at expiration, you could buy a put backspread by selling one $55 put option and buying two $50 put options. If the $55 put option received $5.00 in credit, and the two $50 put options cost $2.00 each, the position would create a $1.00 credit at entry.

If the stock is at or above $55 at expiration, all of the puts expire worthless and the $100 initial credit received is realized as a profit. If the underlying stock price is $50 at expiration, the long $50 strike puts would expire worthless, and the short put will cost $5.00 to close. The $5.00 to close, minus the $1.00 initial credit, results in the maximum loss for the position of -$400.

Call Ratio

Posted on June 26, 2024June 27, 2024 by admin

Call Ratio Spread overview

Call ratio spreads have three components: one long call purchased in-the-money and two short calls sold at a higher strike price out-of-the-money. The short calls will have the same strike price. All three call options have the same expiration date. Call ratio spreads may be opened for a debit or a credit, depending on the pricing of the options contacts, but call ratio spreads are typically established for a credit. Ideally, the stock price closes at the short call strikes at expiration.

Call Ratio Spread market outlook

Call ratio spreads are market neutral to slightly bullish. The strategy depends on minimal movement from the underlying stock to be profitable. To reach maximum profit potential, the underlying stock price would need to rise in price to close at the short strike prices at expiration. Therefore, a slightly bullish bias is an appropriate outlook for a call ratio spread.

If the call ratio spread is initiated for a credit, the profit potential is the amount of credit received plus the width of the spread between the long and short call options. However, if the underlying stock price falls below the long call option, a profit will still be realized. All options would expire worthless, and the initial credit received would remain. Call ratio spreads have undefined risk if the stock price experiences a significant move higher above the short calls.

A call ratio spread is used when the underlying asset is expected to stay within the range between the two strike prices before expiration.

How to set up a Call Ratio Spread

A call ratio spread is a bull call debit spread with an additional call sold at the same strike price as the short call in the spread. The bull call spread results in a risk-defined position with limited profit potential. The goal is for the stock price to close at the short strikes at expiration. This results in the short contracts expiring worthless, and the long call could be sold with the maximum intrinsic value.

If the underlying stock price drops below the long strike, all options expire worthless, and the maximum loss is limited to the debit paid or, if a credit was received at trade entry, the credit will be realized as a profit. However, because of the single naked call, if the underlying asset’s stock price exceeds the short call options, the risk is unlimited.

The debit paid or credit collected at entry will depend on how far in-the-money the long call option is and how far out-of-the-money the short call options are relative to the underlying’s stock price.

Call Ratio Spread payoff diagram

The call ratio spread payoff diagram illustrates the strategy’s different outcomes based on the underlying stock price. Ideally, the stock price closes at the short strike options at expiration. When a call ratio spread is entered, there is potential for either paying a debit or receiving a credit.

If a credit is received, the amount collected, plus the width of the strike prices, is the maximum potential profit for the position. If a debit is paid, the maximum potential profit is the width of the spread between the short and long strikes, minus the amount paid to enter the position.

Maximum gain and loss are limited if the stock price falls below the long call option. All contracts would expire worthless, and the premium paid or received at entry will remain for a profit or loss. Maximum loss is unlimited if the stock price exceeds the break-even point above the short calls.

For example, if a stock is trading at $52, a call ratio spread could be entered with one long call at $50 and two short calls at $55. Assume a $1.00 credit is received. If the stock closes at $55 the maximum profit potential is realized. $600 is the most that can be made on the trade (the width of the spread, $5, plus the $1.00 credit). The short calls would expire worthless, and the long call can be sold for $5, plus the initial $1.00 credit. If the stock closes at $61 on expiration, the short calls will cost $12 combined to exit, but the long call will be worth $11.

Because the position received $1.00 at trade entry, the position will break-even at expiration if the underlying stock is trading at $61. If the stock closes below $50, all options will expire worthless and the original credit of $100 will remain. If the stock closes above $61, the potential loss is unlimited.

Image of call ratio spread payoff diagram showing max profit, max loss, and break-even points

Entering a Call Ratio Spread

A call ratio spread is a bull call spread with a naked call option sold at the same strike price as the short call option in the spread. Call ratio spreads consist of buying-to-open (BTO) one in-the-money long call option and selling-to-open (STO) two out-of-the-money short call options above the current stock price. All options have the same expiration date.

The amount of contracts is variable, but the most common ratios are 2:1, 3:2, and 3:1. For example, if a stock is trading at $52, a call ratio spread could be entered with one long call at $50 and two short calls at $55.

Entering a call ratio spread may result in receiving a credit or paying a debit. The premium depends on multiple factors, including the width of the spread, how far in-the-money and out-of-the-money the options are, and implied volatility skew. For example, if the marketplace perceives an asset to be very bullish in the future, out-of-the-money options may be more expensive than normal, relative to the in-the-money option.

Exiting a Call Ratio Spread

A call ratio spread will experience its maximum profit potential if the stock price is exactly the same as the short strike options at expiration. In this scenario, or if the stock price closes below the short options and above the long option, the short call options expire worthless. The long call option that is in-the-money may be sold.

If the stock price closes below the long call option, all three options will expire worthless, and no further action will be needed. If the stock price closes above the short call options, all three options will be in-the-money and need to be closed if exercise and assignment are to be avoided.

Time decay impact on a Call Ratio Spread

Time decay, or theta, works in the advantage of the call ratio spread. Every day the time value of an options contract decreases, which will help to lower the value of the two short calls. Ideally, the underlying stock experiences minimal movement, and theta will exponentially lose value as the strategy approaches expiration. The decline in time value may allow the investor to purchase the short options contracts for less money than initially sold, while the in-the-money long option will retain its intrinsic value.

Implied volatility impact on a Call Ratio Spread

Call ratio spreads benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower option premium prices. Ideally, when a call ratio spread is initiated, implied volatility is higher than where it will be at exit or expiration. Lower implied volatility will help to decrease the value of the two short calls more rapidly. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the short options.

Adjusting a Call Ratio Spread

Call ratio spreads may be adjusted before expiration to extend the trade duration or alter the ratio in the spread. If the underlying security rises and challenges the short calls, buying additional long calls to reduce the call spread to a 1:1 ratio caps the position’s risk. Adjustments will most likely come with additional cost to the position, which will increase the risk, lower the profit potential, and narrow the break-even points. Furthermore, because call ratio spreads consist of two short contracts, assignment is a risk any time before expiration.

External factors, such as dividends, may need to be considered when deciding to adjust or close a call ratio spread position. If an investor wants to avoid assignment risk, and/or needs to extend the trade into the future to allow the strategy more time to become profitable, the entire position can be closed and reopened at a future expiration date with the same, or new, strike prices. Typically, if the stock moves above the break-even point, the position is closed instead of adjusted.

Rolling a Call Ratio Spread

Call ratio spreads require the underlying stock price to be at or near a specific price at expiration. If the position is not profitable and an investor wishes to extend the length of the trade, the call ratio spread may be closed and reopened for a future expiration date. Because more time equates to higher options prices, the rollout may cost money and add risk to the position, depending on the initial credit or debit of the spread.

If the stock price has moved above the short call options, there may be an opportunity to close out the existing position and enter a new spread with new strike prices closer to the underlying asset’s current price. However, doing so would not make sense if the new net debit paid exceeds the spread’s width, as the position would no longer be profitable.

Hedging a Call Ratio Spread

The most common hedge for a call ratio spread is the purchase of additional long calls to reduce the spread ratio. Purchasing additional long call options converts the call ratio spread into a bull or bear call spread, depending on the outlook for the security at the time of the hedge. Protection from lower movement in the underlying stock is not necessary because the long call option has defined risk to the downside.

However, if an investor wants to protect against a significant increase in the stock price, a long call option may be purchased above the short strikes. This would effectively create a bear call spread and protect against an increase in the underlying stock price. If the stock moves above the break-even point, the position may be closed instead of hedged.

FAQs

What is a call ratio spread?

A call ratio spread is a multi-leg, neutral strategy with undefined risk and limited profit potential. The strategy looks to take advantage of a drop in volatility, time decay, and little or no movement from the underlying asset.

A call ratio spread is a bull call spread with an additional short call option sold at the same strike price and expiration date as the short call option in the spread. Call ratio spreads consist of buying-to-open (BTO) one in-the-money long call option and selling-to-open (STO) two out-of-the-money short call options above the current stock price. All options have the same expiration date.

The amount of contracts is variable, but the most common ratios are 2:1, 3:2, and 3:1. For example, if a stock is trading at $52, a call ratio spread could be entered with one long call at $50 and two short calls at $55.

Is a call ratio bullish or bearish?

Call ratio spreads are typically neutral to slightly bullish. However, if the stock price increases beyond the short call option’s strike price there is unlimited risk.

What is a 1 x 2 call ratio spread?

A 1 x 2 call ratio spread is also known as a call ratio spread. A 1 x 2 call ratio spread is a multi-leg, neutral strategy with undefined risk and limited profit potential.

What is an example of a call ratio spread?

If a stock is trading at $100, a call ratio spread could be entered with one long call at $95 and two short call options at $105. The amount of contracts is variable, but the most common ratios are 1:2 and 2:3.

Call Diagonal

Posted on June 26, 2024June 27, 2024 by admin

Call Diagonal Spread overview

Call diagonal spreads consist of two call options. Call diagonals can be bullish or bearish depending on their setup.

Call diagonal spreads are bearish when a short call option is sold, and a long call option is purchased at a higher strike price and a later expiration date than the short call.

A bearish call diagonal spread is a combination of a call credit spread and a call calendar spread and is typically opened for a credit.

Bullish diagonal spreads, also known as a poor man’s covered call, are typically opened for a debit.

This strategy guide focuses on bearish call diagonal spreads.

The strategy is successful if the underlying stock price is below the short call at the front-month expiration. The back-month long call option serves as protection and defines the strategy’s risk if the stock price is above the short call at the front-month expiration.

Call Diagonal Spread market outlook

A call diagonal spread is entered when an investor believes the stock price will be neutral or bearish short-term. The near-term short call option benefits from a decline in price from the underlying stock, similar to a bear call spread. The long call option will retain value better than a standard bear call spread because of its extended time horizon. An increase in volatility will also help add value to the long contract’s premium and potentially help offset a decline in value from the decreasing stock price.

The objective is for the underlying stock price to close below the short call option at the first expiration date. The short call option would expire worthless, and the long call option would still have extrinsic value. At this point, an investor could choose to close the long call option or continue to hold the position if they believe the stock will reverse and go higher. Another short call option could also be sold to bring in additional credit. The short contract would need to have the same expiration date as the long call. This would create a traditional spread position.

How to set up a Call Diagonal Spread

A call diagonal spread is a combination of a bear call credit spread and a call calendar spread. A call diagonal spread is created by selling-to-open (STO) a call option and buying-to-open (BTO) a call option at a higher strike price, with a later expiration date.

Call diagonal spreads are typically opened for a credit, though a debit may be paid. The pricing at entry is dependent on the width of the spread between the two strike prices and the time until expiration of the contracts. A tight spread width will result in a lower credit because the long option will be closer to the money and have more value. More time until expiration equates to more expensive options pricing and will also impact whether the position is opened for a debit or credit.

The width of the spread, minus the initial credit, is the maximum risk for the trade if the short call option is in-the-money and both options are closed at the front-month expiration. If the short call expires out-of-the-money, the long call may be sold for its extrinsic value. The credit received from selling the long call, plus the original credit received, will be the realized profit. The profit potential is unlimited if the short call expires worthless and the underlying stock price rises and/or implied volatility has a significant increase.

Call Diagonal Spread payoff diagram

The payoff diagram for a call diagonal spread is variable and has many different outcomes depending on when the options trader decides to exit the position. The maximum risk is defined at entry by the width of the spread minus the credit received.

If the stock price is above the short call at the front-month expiration, the option would need to be exited to avoid assignment. The long call may also be sold at the front-month expiration, or the investor could continue to hold the option if they believe the stock price will continue to increase. This would increase the maximum risk on the trade as the long call has the potential to expire out-of-the-money worthless.

If the stock price is below the short call strike at the front-month expiration–which is the diagonal spread goal–the short contract will expire worthless. The long call option will still have extrinsic time value. The investor can choose to exit the long call at this point or continue to hold the position.

For example, if a stock is trading at or below $50, and an investor believes the stock will stay below $50 in the near future, a call diagonal spread could be entered by selling a $50 call option and purchasing a $55 call option with a later expiration date. If the position collects $1.00 in credit, the max loss at the front-month expiration would be -$400.

The max potential profit will be variable and will depend on whether or not the long call is closed at the front-month expiration. However, if a credit is collected when the trade is entered, and the short call expires worthless, the $100 credit will be a guaranteed profit. The long call could be sold at the front-month expiration to create additional profit, or the long position could be held if the investor believes the underlying stock price will increase.

Image of call diagonal spread payoff diagram showing potential profit and loss outcomes

Entering a Call Diagonal Spread

A call diagonal spread consists of selling-to-open (STO) a short call option and buying-to-open (BTO) a long call option at a higher strike price and a later expiration date.

For example, suppose a stock is trading at or below $50, and an investor believes the stock will stay below $50 in the near future. In that case, a call diagonal spread could be entered by selling a $50 call option and purchasing a $55 call option with a later expiration date. The farther out-of-the-money the strike prices are at trade entry, the more bullish the outlook for the underlying stock price.

Exiting a Call Diagonal Spread

The decision to exit a call diagonal spread will depend on the underlying asset’s price at the expiration of the short call contract. If the stock price is below the short call, the option will expire worthless. The long call option will be out-of-the-money and have time value remaining. The extrinsic time value will depend on the length of time until expiration and the strike price relative to the stock price.

Time value, or theta, works against the long option, and the contract will lose value exponentially as it approaches expiration. A sell-to-close (STC) order will be entered when the investor wishes to exit the long call position. If the underlying stock price is above the short call at the first expiration date, both options may be closed to exit the position. This will result in the maximum loss on the trade.

If the investor chooses only to close the in-the-money short call option, more risk is possible. The stock could reverse, and the long call option will lose value. However, if the stock price were to increase, a profit could still be realized.

Time decay impact on a Call Diagonal Spread

Time decay, or theta, will positively impact the front-month short call option and negatively impact the back-month long call option of a call diagonal spread. Typically, the goal is for the short call option to expire out-of-the-money. If the stock price is below the short call at expiration, the contract will expire worthless. The passage of time will help reduce the full value of the short call option.

The time decay impact on the back-month option is not as significant early in the trade, but the theta value will increase rapidly as the second expiration approaches. This may influence the decision related to exiting the position.

Implied volatility impact on a Call Diagonal Spread

Implied volatility has a mixed effect on call diagonal spreads. The bear call spread component of the diagonal spread will be negatively impacted by increased implied volatility while the calendar spread will benefit. Ideally, the front-month short call option will expire out-of-the-money and be unaffected by changes in implied volatility. The position will experience the most profit if volatility is higher at the time of the second expiration. However, the stock price will need to be below the options’ strike price at the first expiration.

If implied volatility increases significantly early in the first expiration, the spread between the two contracts will decline. After the near-term expiration, the more implied volatility, the better. Higher implied volatility means there is a greater expectation of a large price change, which is ideal for the remaining long call position that is out-of-the-money when the first contract expires.

Adjusting a Call Diagonal Spread

Call diagonal spreads can be adjusted during the trade to increase credit. If the underlying stock price declines rapidly before the first expiration date, the short call option can be purchased and sold at a lower strike closer to the stock price. This will collect more premium, but the risk increases to the adjusted spread width between the strikes of the near-term expiration contract and long-term expiration contract if the stock reverses. If the short call option expires out-of-the-money, and the investor does not wish to close the long call, a new position may be created by selling another short call option.

The ability to sell a second call contract after the near-term contract expires or is closed is a key component of the call diagonal spread. The spread between the short and long call options would need to be at least the same width to avoid adding risk. Selling a new call option will collect more credit, and may even lead to a risk-free trade with unlimited upside potential if the net credit received is more than the width of the spread between the options.

Rolling a Call Diagonal Spread

The short call option of a call diagonal spread can be rolled lower if the underlying stock price drops. The short call may be purchased and resold at a lower strike price to collect more credit and increase profit potential. Ideally, the stock still closes below the short option, so it expires worthless. The long call option may have extrinsic value remaining to help reduce the loss or potentially make a profit.

Hedging a Call Diagonal Spread

Call diagonal spreads are not typically hedged. The strategy has a specific goal and defined risk. The position can be adjusted lower if the underlying stock price drops. The call diagonal spread holder may do nothing and continue to hold the position, let the near-term contract expire worthless, and see if the underlying security rises during the longer-term expiration. If the near-term contract is closed and a new contract is sold, the long call position may potentially be “free” if the combined credits of the two short contracts exceeds the debit required to enter the long call position. The reduced cost of the long call minimizes or eliminates the break-even point on the position.

FAQs

What is a call diagonal spread?

A call diagonal spread is a risk-defined options strategy with limited profit potential. Call diagonal spreads are bearish and capitalize on time decay.

A call diagonal spread is a combination of a call credit spread and a call calendar spread. Call diagonal spreads are created by selling-to-open (STO) a call option and buying-to-open (BTO) a call option at a higher strike price, with a later expiration date.

Is a diagonal call spread bullish or bearish?

Diagonal call spreads are bearish. You can exit the strategy for a profit if the underlying stock price is below the short call option at the front-month expiration and the long call with a later expiration date is sold.

Holding the long call past the short call’s expiration date increases risk and profit potential. A long call is bullish if the stock price increases, the long call benefits.

What are the advantages of call diagonal spreads?

You can open a call diagonal spread if you believe the stock price will be neutral or bearish short-term. The near-term short call option benefits from the underlying stock’s price dropping, time decay, and decreasing volatility, similar to a bear call spread. The long call option will retain value better than a standard bear call spread because of its extended time horizon. An increase in volatility could also help add value to the long call contract’s premium and potentially help offset a price increase from the underlying stock price.

What are the risks of a call diagonal spread?

A call diagonal spread’s payoff diagram is variable and has multiple outcomes depending on when the options trader chooses to exit the position. The maximum risk is defined at trade entry, if you close both options at the front month expiration. To calculate the max risk, subtract the credit received by the spread’s width.

Call Calendar

Posted on June 26, 2024June 27, 2024 by admin

Call Calendar Spread overview

Call calendar spreads consist of two call options. A short call option is sold, and a long call option is purchased at the same strike price but with a later expiration date than the short call. A call calendar spread looks to capitalize on minimal price movement and time decay in the near-term call option and rising volatility in the long-term call option. The strategy is successful if the underlying stock price stays at or below the short call before the front-month expiration, then moves up beyond the back-month long call option, preferably with increasing volatility. A debit will be paid to enter the position because the longer-dated options will be more expensive. The initial cost to enter the trade is the maximum loss at the front-month expiration.

Call Calendar Spread market outlook

A call calendar spread is purchased when an investor believes the stock price will be neutral or slightly bearish short-term. The position would then benefit from an increase in price after the short-term contract expires and before the longer-dated contract is closed. The position has a maximum loss defined by the cost to enter the trade. If the underlying stock price is above the short call at expiration, the long call may be exercised to cancel out the assignment of the short shares. The position would then be closed for a max loss.

Ideally, the stock price is at or just below the short call at the time of expiration, and the short contract would expire worthless. A decision will then need to be made to either exit the long call position or wait to see if the stock price and/or implied volatility increases before the second expiration date. The further out-of-the-money the strike prices are at trade entry, the more bullish the outlook on the underlying security.

How to set up a Call Calendar Spread

A call calendar spread is created by selling-to-open (STO) a short-term call option and buying-to-open (BTO) a call option with a later expiration date. Both call options will have the same strike price. Long call calendar spreads will require paying a debit at entry.

The initial cost is the maximum risk for the trade if the short call option is in-the-money and/or both options are closed at the front-month expiration. The profit potential is unlimited if the short call expires worthless, and the underlying stock price and/or implied volatility has a significant increase.

Call Calendar Spread payoff diagram

The payoff diagram for a call calendar spread is variable and has many different outcomes depending on when the options trader decides to exit the position. The maximum risk is defined at entry by the debit paid to enter the spread, if both options are exited at the first expiration.

If the stock price is above the short call options’ strike at the front-month expiration and the investor chooses to close both options, the loss would be the trade’s initial cost. If the stock price is below the short call strike at expiration–which is the goal of the calendar spread–the short contract will expire worthless. The long call option will still have extrinsic time value remaining. The investor can choose to exit the long call at this point or continue to hold the position with no increased risk.

At the near-term expiration the payoff diagram slightly resembles an inverted V. After the near-term expiration, if the long call option is held, the payoff diagram is the same as a long call. If the stock price and/or implied volatility increases before the long call’s expiration date, the position will gain value. If the stock price drops, the extrinsic value of the long call will decrease.

For example, if a stock is trading at or below $50, and an investor believes the stock will stay below $50 before the first expiration, a call calendar spread could be entered by selling a $50 call option and purchasing a $50 call option with a later expiration date. Assume the short call was sold for $2.00 and the long call was purchased for $4.00. The initial debit of -$2.00 would be the maximum loss at the first expiration if both options are closed. If the short call is out-of-the-money at expiration, it will expire worthless, and the long call could be sold for its extrinsic value. The payoff diagram below illustrates a $100 profit as the outcome with the underlying stock trading at-the-money at the first expiration if the long call is sold with $3.00 of extrinsic value remaining.

However, the long call’s value may increase or decrease after the first expiration, depending on the price movement of the underlying security. If the short call is in-the-money at the first expiration and the long call is not sold simultaneously, the maximum risk may exceed -$200 if the stock subsequently reverses before the second expiration.

Image of call calendar spread payoff diagram showing potential profit and loss outcomes

Entering a Call Calendar Spread

A call calendar spread consists of selling-to-open (STO) a short call option and buying-to-open (BTO) a long call option at the same strike price, but with a later expiration date.

For example, suppose a stock is trading at or below $50, and an investor believes the stock will stay below $50 in the near future. In that case, a call calendar spread could be entered by selling a short-term $50 call option and purchasing a $50 call option with a later expiration date. The long call contract will have a higher premium because it has more extrinsic time value, so the position will cost money to enter. The debit paid will be the maximum risk for the trade at the expiration of the first contract.

The farther out-of-the-money the strike prices are at trade entry, the more bullish the outlook on the underlying’s price.

Exiting a Call Calendar Spread

The decision to exit a call calendar spread will depend on the underlying asset’s price at the expiration of the short call contract. If the stock price is below the short call, the option will expire worthless. The long call option will be out-of-the-money and have time value remaining. The extrinsic time value will depend on the length of time until expiration and the strike price relative to the stock price.

Time value, or theta, works against the long option, and the contract will lose value exponentially as it approaches expiration. A sell-to-close (STC) order will be entered when the investor wishes to exit the position. The credit received when selling the long option, minus the original debit paid, will result in a profit or loss. If the underlying stock price is above the short call at the first expiration date, both options may be closed to exit the position. This will result in the maximum loss on the trade.

If the investor chooses only to close the in-the-money short call option, there is potential for more risk. The stock could reverse, and the long call option will lose value. However, if the stock price were to increase, a larger profit could still be realized. Legging out of a call calendar spread can increase the risk beyond the initial debit paid, but creates the highest profit potential.

Time decay impact on a Call Calendar Spread

Time decay will positively impact the front-month short call option and negatively impact the back-month long call option of a call calendar spread. Typically, the goal is for the short call option to expire out-of-the-money. If the stock price is below the short call at expiration, the contract will expire worthless. The passage of time will help reduce the full value of the short call option prior to expiration.

Implied volatility impact on a Call Calendar Spread

Implied volatility has a mixed effect on call calendar spreads. Generally, call calendar spreads benefit from an increase in implied volatility. Ideally, the front-month short call option will expire out-of-the-money and be unaffected by changes in implied volatility. The position will experience the most profit if volatility is higher at the time of the second expiration. However, the stock price will need to be below the options’ strike price at the first expiration for the call calendar spread to be successful.

If implied volatility increases significantly early in the near-term expiration, the spread between the two contracts will decline. After the near-term expiration, the more implied volatility, the better. Higher implied volatility means there is a greater expectation of a large price change which is ideal for the remaining long call position. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts.

Adjusting a Call Calendar Spread

Call calendar spreads can be adjusted during the trade to increase credit. If the underlying stock price declines rapidly before the first expiration date, the short call option can be purchased and sold at a lower strike closer to the stock price to receive additional credit.

For example, if a call calendar spread was entered at $50, and the underlying stock has dropped to $40 before the first expiration, the short call could be bought back and resold at $45. This will collect more premium to help offset the initial debit paid, but if the stock reverses, the risk will increase to at least $5.00, the adjusted spread width between the strikes of the near-term expiration contract and long-term expiration contract.

If the underlying stock fails to challenge the strike price before expiration, the spread value has typically widened, allowing the position to be closed for a small profit, and no adjustment is necessary.

Rolling a Call Calendar Spread

The short call option of a call calendar spread can be rolled lower if the underlying stock price drops. The short call may be purchased and resold at a lower strike price to collect more credit and increase profit potential. Ideally, the stock still closes below the short option, so it expires worthless. The long call option may have extrinsic value remaining to help reduce the loss or potentially make a profit.

Hedging a Call Calendar Spread

Call calendar spreads are not typically hedged. The strategy has a specific goal and defined risk. The position can be adjusted lower if the underlying stock price drops. The call calendar spread holder may do nothing and continue to hold the position, allowing the near-term contract to expire worthless, and see if the underlying security recovers during the longer-term expiration.

FAQs

What is a call calendar spread?

A call calendar spread is a risk-defined options strategy with unlimited profit potential. Call calendar spreads are neutral to bearish short-term and slightly bullish long-term. To open a call calendar spread, sell-to-open (STO) a short call option and buy-to-open (BTO) a long call option at the same strike price but with a later expiration date.

For example, if a stock is trading at or below $50, and you believe the stock will stay below $50 in the near future, you could enter a call calendar spread by selling a $50 call option and purchasing a $50 call option with a later expiration date. The long call contract will have a higher premium because it has more extrinsic time value, so you will likely pay a debit to enter the trade. The debit paid will be the maximum risk for the trade at the expiration of the first contract.

When to exit a calendar call spread?

Exiting a calendar call spread depends on the underlying asset’s price at the short call contract’s expiration and your future outlook for the stock. If the stock price is below the short call, the option will expire worthless. The long call option will be out-of-the-money and have time value remaining. The extrinsic time value will depend on the length of time until expiration and the strike price relative to the stock’s price.

Legging out of a call calendar spread can increase the risk beyond the initial debit paid but creates the highest profit potential. If you choose to only close the in-the-money short call option, there is potential for more risk. The stock could reverse, and the long call option will lose value. However, if the stock price were to increase, a larger profit could be realized.

Is a calendar call spread bullish?

Call calendar spreads are bearish short-term and slightly bullish long-term.

Bear Put Spread

Posted on June 26, 2024June 27, 2024 by admin

Bear Put Debit Spread overview

Bear put spreads, also known as long put spreads, are debit spreads that consist of buying a put option and selling a put option at a lower price. The strategy looks to take advantage of a price decrease from the underlying asset before expiration. Increased implied volatility may also benefit the bear put debit spread.

Bear Put Debit Spread market outlook

A bear put debit spread is entered when the buyer believes the underlying asset price will decrease before the expiration date. Bear put spreads are also known as put debit spreads because they require paying a debit at trade entry. Risk is limited to the debit paid at entry. The further out-of-the-money the bear put debit spread is initiated, the more aggressive the outlook.

How to set up a Bear Put Debit Spread

A bear put debit spread is made up of a long put option with a short put option sold at a lower strike price. The debit paid is the maximum risk for the trade. The maximum profit potential is the spread width minus the premium paid. To break even on the position, the stock price must be below the long put option by at least the cost to enter the position.

The closer the strike prices are to the underlying’s price, the more debit will be paid, but the probability is higher that the option will finish in-the-money. The larger the spread width between the long put and the short put, the more premium will be paid, and the maximum potential profit will be higher.

Bear Put Debit Spread payoff diagram

The bear put spread payoff diagram clearly outlines the defined risk and reward of debit spreads. Bear put spreads require a debit when entered. The debit paid is the maximum potential loss for the trade. Because a short option is sold to reduce the trade’s cost basis, the maximum profit potential is limited to the spread width minus the debit paid.

For example, if a $5 wide bear put spread costs $1.00, the maximum profit is $400 if the stock price is below the short put at expiration, and the maximum loss is $100 if the stock price is above the long put at expiration. The break-even point would be the long put strike minus the premium paid.

Image of bear put spread payoff diagram showing max profit, max loss, and break-even points

Entering a Bear Put Debit Spread

A bear put spread consists of buying-to-open (BTO) a put option and selling-to-open (STO) a put option at a lower strike price, with the same expiration date. This will result in paying a debit. Selling the lower put option will help reduce the overall cost to enter the trade and define the risk while limiting the profit potential.

For example, an investor could buy a $50 put option and sell a $45 put option. If the spread costs $1.00, the maximum loss possible is -$100 if the stock closes above $50 at expiration. The maximum profit is $400 if the stock closes below $45 at expiration. The break-even point would be $49.

Buy-to-open: $50 put
Sell-to-open: $45 put

Bear put debit spreads can be entered at any strike price relative to the underlying asset. In-the-money options will be more expensive than out-of-the-money options. The further out-of-the-money the spread is purchased, the more bearish the bias.

Exiting a Bear Put Debit Spread

A bear put spread is exited by selling-to-close (STC) the long put option and buying-to-close (BTC) the short put option. If the spread is sold for more than it was purchased, a profit will be realized. If the stock price is below the short put option at expiration, the two contracts will offset, and the position will be closed for a full profit.

For example, if a put debit spread is opened with a $50 long put and a $45 short put, and the underlying stock price is below $45 at expiration, the broker will automatically sell shares at $50 and buy shares at $45. If the stock price is above the long put option at expiration, both options will expire worthless, and the full loss of the original debit paid will be realized.

Time decay impact on a Bear Put Debit Spread

Time decay, or theta, works against the bear put debit spread. The time value of the long options contract decreases exponentially every day. Ideally, a large move down in the underlying stock price occurs quickly, and an investor can capitalize on all the remaining extrinsic time value by exiting the position.

Implied volatility impact on a Bear Put Debit Spread

Bear put debit spreads benefit from an increase in the value of implied volatility. Higher implied volatility results in higher options premium prices. Ideally, when a bear put debit spread is initiated, implied volatility is lower than it is at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts.

Adjusting a Bear Put Debit Spread

Bear put debit spreads have a finite amount of time to be profitable and have multiple factors working against their success. If the underlying stock does not move far enough, fast enough, or volatility decreases, the spread will lose value rapidly and result in a loss. Bear put spreads can be adjusted like most options strategies but will almost always come at more cost and, therefore, add risk to the trade and extend the break-even point.

If the stock price has moved up, a bull call debit spread could be added at the same strike price and expiration as the bear put spread. This creates a reverse iron butterfly and allows the call spread to profit if the underlying price continues to increase. However, the additional debit spread will cost money and extend the break-even point.

For example, if a $5 wide call debit spread centered at the same $50 strike price costs $2.00, an additional $200 of risk is added to the trade, and the profit potential decreases by $200.

Buy-to-open: $50 call
Sell-to-open: $55 call

Image of a bear put spread adjusted to a reverse iron butterfly

Rolling a Bear Put Debit Spread

Bear put debit spreads can be rolled out to a later expiration date if the underlying stock price has not moved enough. To roll the position, sell the existing bear put spread and purchase a new spread at a later expiration date. This requires paying another debit and will increase the risk, but will extend the duration of the trade.

For example, if the original bear put spread has a March expiration date and cost $1.00, an investor could sell-to-close (STC) the entire spread and buy-to-open (BTO) a new position in April. If this results in a $1.00 debit, the maximum profit potential decreases by $100 per contract and the maximum loss increases by $100 per contract. The new break-even price will be $48.

Image of a bear put spread rolled out to a later expiration date

Hedging a Bear Put Debit Spread

Bear put debit spreads can be hedged if the underlying stock’s price has increased. To hedge the bear put spread, purchase a bull call debit spread at the same strike price and expiration as the bear put spread. This would create a long butterfly and allow the position to profit if the underlying price continues to increase. The additional debit spread will cost money and extend the break-even points.

FAQs

How do you close a bear put debit spread?

To close a bear put spread, sell-to-close (STC) the long put option and buy-to-close (BTC) the short put option . If the spread is sold for more than it was purchased, a profit will be realized. If the stock price is below the short put option at expiration, the two contracts will offset, and the position will be closed for a full profit. If the stock price is above the long put option at expiration, both options will expire worthless, and the full loss of the original debit paid will be realized.

What is a bear put debit spread?

A bear put debit spread, or long put spread, is a bearish strategy with limited profit potential and defined risk. Bear put spreads are debit spreads that consist of buying a put option and selling a put option at a lower price. The strategy looks to take advantage of a decline in price from the underlying asset before expiration. Increased implied volatility will also benefit the bear put debit spread.

Can I close a bear put debit spread early?

A bear put debit spread may be closed anytime before expiration. A bear put debit spread is exited by selling-to-close (STC) the long put option and buying-to-close (BTC) the short put option. If the spread is sold for more than it was purchased, a profit will be realized.

Is a debit put spread bullish or bearish?

A debit put spread, also known as a bear put spread, is a bearish strategy with limited profit potential and defined risk. Debit put spreads benefit when the underlying price drops and/or volatility increases.

Bear Call Spread

Posted on June 26, 2024June 27, 2024 by admin

Bear Call Credit Spread overview

Bear call spreads, also known as short call spreads, are credit spreads that consist of selling a call option and purchasing a call option at a higher price. The strategy looks to take advantage of a decline in price from the underlying asset before expiration. Time decay and decreased implied volatility will also benefit the bear call credit spread.

Bear Call Credit Spread market outlook

A bear call credit spread is entered when the seller believes the price of the underlying asset will be below the short call option’s strike price on or before the expiration date. Bear call spreads are also known as call credit spreads because they collect a credit when the trade is entered. The risk is limited to the width of the spread minus the credit received. The break-even price for the bear call credit spread is the short strike price plus the net credit received. Time decay and decreased implied volatility will also help the position become profitable. The closer the short strike price is to the underlying’s price, the more credit will be received at trade entry.

How to set up a Bear Call Credit Spread

A bear call credit spread is made up of a short call option with a long call option purchased at a higher strike price. The credit received is the maximum potential profit for the trade. The maximum risk is the width of the spread minus the credit received. The closer the strike prices are to the underlying’s price, the more credit will be collected, but the probability is higher that the option will finish in-the-money. The larger the width of the spread between the short option and the long option, the more premium will be collected. The outlook is more aggressive and the maximum risk will be higher.

Bear Call Credit Spread payoff diagram

The bear call credit spread payoff diagram clearly outlines the defined risk and reward of credit spreads. Bear call spreads collect a credit when entered. The credit received is the maximum potential profit for the trade. Because long options are purchased for protection, the maximum risk is limited to the width of the spread minus the credit received.

For example, if a $5 wide bear call spread collects $1.00 of credit, the maximum gain is $100 if the stock price is below the short call at expiration. The maximum loss is $400 if the stock price is above the long call at expiration. The break-even point would be the short call strike plus the premium received.

Image of bear call spread payoff diagram showing max profit, max loss, and break-even points

Entering a Bear Call Credit Spread

A bear call spread consists of selling-to-open (STO) a call option and buying-to-open (BTO) a call option at a higher strike price, with the same expiration date. This will result in a credit received. Buying the higher call option will reduce the overall premium collected to enter the trade but will define the position’s risk to the width of the spread minus the credit received.

For example, if an investor believes a stock will be below $50 at expiration, they could sell a $50 call option and buy a $55 call option. If this results in a $1.00 credit, the maximum profit potential is $100 if the stock closes below $50 at expiration, and the maximum loss is $400 if the stock closes above $55 at expiration.

Sell-to-open: $50 call
Buy-to-open: $55 call

The closer to the underlying stock price the spread is sold, the more bearish the bias.

Exiting a Bear Call Credit Spread

A bear call credit spread is exited by buying-to-close (BTC) the short call option and selling-to-close (STC) the long call option. If the spread is purchased for less than it was sold, a profit will be realized. If the stock price is below the short call option at expiration, both options will expire worthless, and the entire credit will be realized as profit. If the stock price is above the long call option at expiration, the two contracts will offset, and the position will be closed for the maximum loss.

For example, if a bear call credit spread is opened with a $50 short call and a $55 long call, and the underlying stock price is above $55 at expiration, the broker will automatically sell shares at $50 and buy shares at $55. If the stock price is between the two call options at expiration, the short option will be in-the-money and need to be repurchased to avoid assignment.

Time decay impact on a Bear Call Credit Spread

Time decay, or theta, works to the advantage of the bear call credit spread strategy. Every day the time value of an options contract decreases. Theta will exponentially lose value as the options approach expiration. The decline in value may allow the investor to purchase the options for less money than initially sold, even if a significant drop in price does not occur.

Implied volatility impact on a Bear Call Credit Spread

Bear call credit spreads benefit from a decrease in the value of implied volatility. Lower implied volatility results in lower option premium prices. Ideally, when a bear call credit spread is initiated, implied volatility is higher than it is at exit or expiration. Future volatility, or vega, is uncertain and unpredictable. Still, it is good to know how volatility will affect the pricing of the options contracts.

Adjusting a Bear Call Credit Spread

Bear call spreads can be adjusted if the underlying stock price has moved up and the position is challenged. An investor has two choices to maximize the probability of success as the position approaches expiration.

If the stock price has increased, an opposing bull put credit spread can be opened below the call spread to create an iron condor. Additional credit will be received and no additional risk will be added to the position if the spread width and number of contracts remain the same.

For example, if a $45 / $40 put credit spread is added to the original position and collects $1.00 of premium, the break-even point will be extended up and give the position a higher probability of profit while reducing risk. However, if the stock reverses, the bull put spread could become challenged.

Sell-to-open: $45 put
Buy-to-open: $40 put

Image of bear call spread adjusted to an iron condor

If the stock price has increased substantially and the short option is in-the-money, an opposing bull put credit spread can be opened with the same strike price and expiration date as the call spread. This will create an iron butterfly. Additional credit will be received and no additional risk will be added to the position if the spread width and number of contracts remain the same. A credit spread adjusted to an iron butterfly will have more profit potential and less risk than an iron condor, but the position’s range of profitability ($47 – $53) is smaller than an iron condor.

For example, if a put credit spread centered at the same $50 strike price collects an additional $2.00 of credit, the break-even point will be extended up and give the position a higher probability of profit while reducing risk. However, if the stock reverses, the bull put spread could become challenged.

Sell-to-open: $50 put
Buy-to-open: $45 put

Image of bear call spread adjusted to an iron butterfly

Rolling a Bear Call Credit Spread

Bear call spreads can be rolled out to a later expiration date to extend the duration of the trade. Rolling the position for a credit reduces risk and extends the break-even point. To roll the position, purchase the existing bear call credit spread and sell a new spread with a later expiration date.

For example, if the original bear call spread has a June expiration date and received $1.00 of premium, an investor could buy-to-close (BTC) the entire spread and sell-to-open (STO) a new position with the same strikes in July. If this results in a $1.00 credit, the maximum profit potential increases by $100 per contract and the maximum loss decreases by $100 per contract. The new break-even price will be $52.

Image of a bear call spread rolled out to a later expiration date

Hedging a Bear Call Credit Spread

Bear call credit spreads can be hedged to help minimize the position’s risk while increasing profit potential. If the stock price has moved up, an opposing bull put credit spread can be opened with the same spread width and expiration date as the bear call spread. This brings in additional credit while reducing the maximum risk. The new spread helps to offset the loss of the original position.

FAQs

What is a bear call credit spread?

A bear call credit spread (also known as a short call spread) is a risk-defined, bearish strategy with limited profit potential. Bear call spreads are credit spreads that consist of selling a call option and purchasing a call option at a higher strike price with the same expiration date.

A bear call credit spread is opened when the seller believes the price of the underlying asset will be below the short call option’s strike price on or before the expiration date. Time decay and decreasing implied volatility will also benefit the bear call credit spread.

How do you close a bear call credit spread?

A bear call credit spread is exited by buying-to-close (BTC) the short call option and selling-to-close (STC) the long call option. If the spread is purchased for less than it was sold, a profit will be realized. If the stock price is below the short call option at expiration, both options will expire worthless, and the entire credit will be realized as profit. If the stock price is above the long call option at expiration, the two contracts will offset and the position will be closed. If the stock price is between the two call options at expiration, the short option will be in-the-money and need to be repurchased to avoid assignment.

How do you break-even on a short call spread?

To calculate a short call spread’s break-even price, add the credit received to the position’s short call strike.

For example, a bear call spread with a $50 short call option that collects $1.00 of credit has a break-even price is $51.

What is a short call spread?

A short call spread is a bearish strategy with limited profit potential and defined risk. Short call spreads benefit from theta decay and decreasing volatility.

How does a short call spread work?

To open a bearish short call spread, sell-to-open a call option and buy-to-open a call option at a higher strike price with the same expiration date and same number of contracts.

Short Call

Posted on June 26, 2024June 27, 2024 by admin

Short Call overview

Selling a naked call option is a levered alternative to short selling stock. Selling single options is considered “naked” because there is no risk protection if the stock moves against the position.

Because options are levered instruments, each short call contract is equivalent to selling 100 shares of stock. Naked call options require margin to protect against large price increases in the underlying asset.

Short Call market outlook

A short call is sold when the seller believes the price of the underlying asset will be below the strike price on or before the expiration date and implied volatility will decrease. The closer the strike price is to the underlying’s price, the more credit will be received.

Selling a call option can be used to enter a short position if the investor wishes to sell the underlying stock. Because selling options collects a premium, initiating a short position with a short call reduces the cost basis if the call option is ultimately assigned to the option seller.

How to set up a Short Call

A short call position is initiated when a seller writes a call option contract. Call options are listed in an options chain and provide relevant information for every strike price and expiration available, including the bid and ask price. The credit received at trade entry is called the premium. Market participants consider multiple factors to assess the option premium’s value, including the strike price relative to the stock price, time until expiration, and volatility.

Short Call payoff diagram

The payoff diagram for a short call represents the risk involved with selling naked options. Profit potential is limited to the amount of credit received when the call is sold. However, the risk is unlimited if the underlying asset experiences an increase in price.

For example, if a short call option with a strike price of $100 is sold for $5.00, the maximum profit potential is $500. The maximum loss is undefined above the break-even point. The strike price plus the premium collected equals the break-even price of $105. If the underlying stock price is above the break-even point at expiration, the position will result in a loss.

Short call payoff diagram showing max profit, max loss, and break-even point

Entering a Short Call

To enter a short call position, a sell-to-open (STO) order is sent to the broker. The order is either filled at the asking price (market order) or at the minimum price an investor is willing to recieve (limit order). Once a call option is sold, cash is credited to the trading account.

Sell-to-open: $100 call

Because selling call options has significant undefined risk, the broker will hold margin against the account to cover potential losses. The margin amount depends on the broker, the stock’s price, and market volatility. Margin is not static and may increase or decrease as volatility fluctuates. The higher the volatility, the more margin required to hold the short call position.

Exiting a Short Call

There are multiple ways to exit a short call position. Anytime before expiration, a buy-to-close (BTC) order can be entered, and the contract will be purchased at the market or limit price. The premium paid will be debited from the account. If the contract is purchased for more premium than initially collected, a loss is realized. If the contract is purchased for less premium than initially collected, a profit is realized.

The buyer of the long call contract can choose to exercise the option at any time, and the seller is obligated to sell 100 shares at the strike price. If the short call option is in-the-money (ITM) at expiration, the option will automatically be assigned to the option seller. If the stock price is below the strike price at expiration, the option is out-of-the-money (OTM). The contract will expire worthless, and the seller will keep the entire premium initially collected.

Time decay impact on a Short Call

Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. All else being equal, options contracts with more time until expiration have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the option price goes down. Therefore, time decay, or theta, works in favor of call option sellers because an option’s value will decrease as expiration approaches.

Implied volatility impact on a Short Call

Implied volatility reflects the possibility of future price movements. Higher implied volatility results in higher option prices because there is an expectation the price may move more than expected in the future. As implied volatility decreases, a call option contract will lose value and the seller may purchase the contract for less money than it was sold. Options sellers benefit when implied volatility decreases before expiration.

Adjusting a Short Call

Short call positions can be managed during a trade. A single-leg short call option can be adjusted to minimize risk.

If the position is challenged, a call option can be purchased at a higher strike price to convert the short call into a bear call credit spread. The long option defines the position’s risk, but lowers the profit potential to the width of the spread minus the credit received.

For example, if a $100 call option is sold, a $110 call option can be purchased. If the long call costs $2.00, the max profit potential is reduced to $3.00. However, the maximum risk is defined at $700 if the underlying asset is above $110 at expiration.

Buy-to-open: $110 call

Image of a short call adjusted to a bear call credit spread

Rolling a Short Call

If an investor wants to extend the trade, the short call option can be rolled out to a future expiration date. Rolling out the option requires buying-to-close (BTC) the short call and selling-to-open (STO) a new call option with the same strike price for a future date. Rolling the option should result in additional credit, which will widen the break-even price and increase the profit potential relative to the original position. The risk will be reduced by the amount of credit received but is still undefined.

For example, if a short call with a $100 strike price has a May expiration date, the position could closed and reopened with a June expiration date. If the adjustment receives $2.00 of premium, the break-even point is extended to $107.

Short call roll out to later expiration date for credit

Hedging a Short Call

To hedge a short call, an investor may sell a put with the same strike price and expiration date, thereby creating a short straddle. This will add additional credit and extend the break-even price above and below the centered strike price of the short straddle, equal to the amount of premium collected. While this increases the premium received, the risk is still undefined and potentially substantial.

For example, if the position is challenged, a put with a $100 strike price could be sold. If an additional $5.00 of credit is received, the max profit increases to $1,000 and the break-even price moves up to $110.

Sell-to-open: $100 put

Image of short call adjusted to a short straddle

Synthetic Short Call

A synthetic short call combines short stock with a short put option at the strike price of the original short stock position. This creates a synthetic short call because the payoff diagram is similar to a single short call option. As with a naked short call, the expectation is that the underlying price will decline before expiration.

Selling the put will collect a premium, but the risk beyond the premium received is still unlimited if the stock continues to rise. The maximum profit potential is limited to the premium collected for the short put. If the stock closes below the strike price at expiration, the short stock will be covered when the short put is exercised, and the shares will offset.

FAQs

What is a short call option?

Short call options are a single-leg bearish strategy with undefined risk. Traders typically use short call options when they believe the underlying stock price will decline and/or volatility will decrease.

How does a short call option work?

Call option buyers have the right to exercise their option at any time and buy shares of stock at the option’s strike price. When you sell a call option, you are required to sell the underlying stock if your option is assigned.

Are call options bullish or bearish?

Short call options are bearish. The position will profit if the underlying stock price is below the strike price at expiration.

Long call options are bullish. To realize a profit, the stock price must be above the strike price by at least the option’s cost.

Can I close a call option before expiration?

Yes, you can close a call option any time before expiration. If you sold a short call, you can buy back the option to exit the trade.

What’s better: short call options or long put options?

Short calls and long puts are both bearish strategies. However, they have different risk/reward profiles. Long put options have defined risk and unlimited profit potential. They work best when volatility increases. Conversely, short call options have unlimited risk, limited profit potential, and work best when volatility declines.

Long Put

Posted on June 26, 2024June 27, 2024 by admin

Long Put overview

Short selling stock is not available for all investors as it requires borrowing stock and uses margin. Furthermore, as opposed to buying a long put, short selling has unlimited risk because the underlying asset has unlimited upside potential.

Long put options give the buyer the right, but no obligation, to sell shares of the underlying asset at the strike price on or before expiration. Because options are levered investments, each contract is equivalent to selling 100 shares of stock. An advantage of using a long put option is that less capital is required to own one contract than the cost of selling 100 shares of stock, and downside risk is limited to the option contract’s cost.

Long Put market outlook

A long put is purchased when the buyer believes the price of the underlying asset will decline by at least the cost of the premium on or before the expiration date. Further out-of-the-money strike prices will be less expensive but have a lower probability of success. The further out-of-the-money the strike price, the more bearish the sentiment for the outlook of the underlying asset.

How to set up a Long Put

A long put position is initiated when a buyer purchases a put option contract. Puts are listed in an option chain and provide relevant information for every strike price and expiration available, including the bid-ask price. The cost to enter the trade is called the premium. Market participants consider multiple factors to assess the value of an option’s premium, including the strike price relative to the stock price, time until expiration, and volatility.

Typically, put options are more expensive than their call option counterparts. This pricing skew exists because investors are willing to pay a higher premium to protect against downside risk when hedging positions.

Long Put payoff diagram

The payoff diagram for a long put is straightforward. The maximum risk is limited to the cost of the option. The profit potential is unlimited until the underlying asset reaches $0. To break even on the trade at expiration, the stock price must be below the strike price by the cost of the long put option.
For example, if a long put option with a $100 strike price is purchased for $5.00, the maximum loss is defined at $500, and the profit potential is unlimited until the stock reaches $0. However, the underlying stock must be below $95 at expiration to realize a profit.

Image of long put payoff diagram showing max profit, max loss, and break-even points

Entering a Long Put

To enter a long put position, a buy-to-open (BTO) order is sent to the broker. The order is either filled at the asking price (market order) or at a specific price an investor is willing to pay (limit order). The call option purchase results in cash debited from the trading account.

Buy-to-open: $100 put

Exiting a Long Put

There are multiple ways to exit a long put position. Anytime prior to expiration, a sell-to-close (STC) order can be entered, and the contract will be sold at the market or a limit price. The premium collected from the sale will be credited to the account.

If the contract is sold for more premium than originally paid, a profit is realized. If the contract is sold for less premium than originally paid, a loss is realized.

If the long put option is in-the-money (ITM) at expiration, the holder of the contract can choose to exercise the option and will sell 100 shares of stock at the strike price. If the long put option is out-of-the-money (OTM) at expiration, the contract will expire worthless and the full loss is realized.

Time decay impact on a Long Put

Time remaining until expiration and implied volatility make up an option’s extrinsic value and impact the premium price. All else being equal, options contracts with more time until expiration will have higher prices because there is more time for the underlying asset to experience price movement. As time until expiration decreases, the option price goes down. Therefore, time decay, or theta, works against options buyers.

Implied volatility impact on a Long Put

Implied volatility reflects the possibility of future price movements. Higher implied volatility results in higher priced options because there is an expectation the price may move more than expected in the future. As implied volatility decreases, the option price goes down. Options buyers benefit when implied volatility increases before expiration.

Adjusting a Long Put

Long put positions can be managed during a trade to minimize loss. A single-leg long put option can be converted into a bear put debit spread.

If the stock price increases, a put option can be sold at a lower strike price to reduce the trade’s risk. This decreases the overall cost of the original position and lowers the break-even price. However, the short put option limits the maximum profit potential to the spread width minus the debit paid.

For example, if a $100 put option was purchased for $5.00, a $95 put option could be sold. If the short put option collects $1.00 of credit, the maximum loss is reduced to $400. The max profit, however, is now capped at $100 if the stock reverses and closes below $95 at expiration. The break-even point is now $1.00 less than the original payoff diagram.

Sell-to-open: $95 put

Image of a long put option adjusted to a bear put debit spread

Rolling a Long Put

Long put positions can be adjusted to extend the time duration of the trade if the stock has not decreased before expiration. The ability to roll the position into the future allows the trade more time to become profitable, but will come at a cost because more time equates to higher options prices.

If an investor wants to extend the trade, the long put option can be rolled out by selling-to-close (STC) the current position and buying-to-open (BTO) an option at a future date. This will likely result in paying a debit and will add cost to the original position.

For example, a $100 put option with a November expiration date could be sold and a $100 put option could be purchased for December. If the original position cost $5.00, and was sold for $2.00, the net loss on the original position is $300 per contract. If the December option costs an additional $5.00, the overall debit of the position is now $8.00. Therefore, the max loss increases to $800 and the break-even point moves out to $92.

Payoff diagram of a long put roll out for a debit

Hedging a Long Put

To hedge a long put, an investor may purchase a call with the same strike price and expiration date, thereby creating a long straddle. If the underlying stock price increases above the strike price, the call will experience a gain in value and help offset the loss of the long put. However, this adds cost to the original trade and widens the break-even price.

For example, if the original long put had a $5.00 debit, and a long call is purchased for an additional $5.00, the risk increases to $1,000 and the break-even points are extended.

Buy-to-open: $100 call

Long put converted to a long straddle to hedge price action

Synthetic Long Put

A synthetic long put combines short stock with a long call option at the strike price of the original short stock position. This creates a synthetic long put because the payoff diagram is similar to a single long put option. The maximum downside risk is limited to the strike price of the long call option, and the profit potential is limited to the difference between the sale price of the short stock position and the call option premium paid.

FAQs

What is a put option?

A long put is a bearish options strategy with defined risk and unlimited profit potential. Buying a put option is an alternative to shorting stock. Unlike short selling a stock, which has unlimited risk, a put option’s maximum risk is limited to the its premium.

Long put options give the buyer the right to sell shares of the underlying stock at the strike price on or before expiration.

How do put options work?

Buying a put option contract gives you the right, but no obligation, to sell shares at the contract’s strike price. Writing a put option obligates you to buy shares at the cotract’s strike price. If you are long a put option, you are bearish on the underlying security.

How to calculate put option profit?

Long puts have unlimited profit potential. A long put option must be below its break even price at expiration to realize a profit. To calculate a long put’s break even price, subtract the contract’s premium from the option’s strike price. The option’s cost is the max loss for the position.