Newbie spreads question - profitable entry?

Discussion in 'Options' started by rickf, Apr 2, 2007.

  1. rickf


    After reading through my broker's site and various other sources of information, I'm ready to 'take the plunge' and try my hand at a spread or two after a while of doing simple call/put options trading.

    Using my broker's Strategy Scan to generate some ideas, I came across something that sounds "too good to be true" and I want to make sure I'm not misunderstanding or overlooking something.

    Taking a slightly-bullish but mostly risk-adverse position, I may want to enter a Bullish Call Spread on ICE (currently trading $127.87)

    Buy 30 MAY 120 Calls @ 13.00
    Sell 30 MAY 125 Calls @ 9.70
    Max Risk 9,900, Max Gain 5,100. Total Investment: 9,900.

    But I'm puzzled -- the Strategy Scan shows the BEP for this transaction is $123.30 and that if the price of the underlying ICE share is $125 or greater, my gain is $5,100. As long as ICE stays at $123.31 or higher, I'm "in the green" with my maximum gain being reached when ICE is at $125 or higher.

    But here's my question: if the current ICE share price is $127.87, does that mean that once this Bullish Call Spread is opened, it's already "in the green" and actually realizing this $5,100 gain? That sounds too good to be true, because if so, I could get the order filled and flip it right away for a $5,100 gain. (Somehow I doubt that --- there's no such thing as free money!)

    Am I missing something here? I've also seen a similar "phenomenon" using a bunch of different stock symbols and strategies -- ie Long Butterflies -- where the underlying's current price is between the spread's BEP and maximum profit price, thus suggesting that you might start off with some degree of profitability right away....which is why I'm MORE than a little skeptical about this!

    Thanks in advance for any insights or clarification.
  2. Maximum profit is only reached at expiration and the breakeven you show is the EXPIRATION breakeven. Since both options still have significant time value premium left they are not worth the maximum value yet.

    A debit spread is like anything else, you buy it for a certain price and want to sell it for a higher price. As sson as you put it on you are not in the green because like anything else you just bought there is a bid/ask spread. If the stock stays where it is the whole time, you need the time value premium to decay off so that the spread will increase in value

  3. General rule of thumb.

    Anytime you're using a DEBIT SPREAD, your max gain should be at least 3X your max risk (max risk being the debit you put down).

    Also, be careful with spreads, understand the risk of early exercise. You may be assigned on your short option prior to the expiration day, which may result in a margin call or other nasty results. If it's a dividend paying stock, you definately want to make the right move prior to it going ex-dividend (which may involve you exercising your long call).
  4. Tums


    This risk graph might help you to visualize the profit/loss scenario.

    The green line represents the P/L at EXPIRATION.

    At expiration,
    - if ICE trades at 125 or more, you get your deposit back, plus $5,100.
    - if ICE trades at 120 or less, you lose the whole investment.

    You are currently at the white colored line. As time progresses, the white line will move towards the green line.
    i.e. even if the ICE doesn't move, you will still enter into the profit zone.

    <img src="">
    • ice.jpg
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  5. rickf


    Bingo. I forgot the strategy scanner was P&L at expiration....I was only looking at it in terms of strike price and totally-disregarding the matter of time decay.

  6. If someone exercises your short call early in a bull call spread you should send them a nice thank you note since doing so allows you to earn the maximum profit from the spread simply by exercising the long to cover and make $5.00 minus commissions/fees.

    Early exercise is not a risk for a bull call spread, it is a blessing.

  7. That's very true, but remember, for most brokers

    - Margin on a spread is the amount between the spread (in this case, $500 / contract)
    - Margin on stock is 50%, in this case, Around $60 / share, or $6000 / contract

    Being assigned early can easily result in a margin call, and if your broker auto-liquidates, it might be a serious issue.
  8. cdowis


    One modest suggestion,

    when you "take the plunge", use one contract until you know what is going on. Thirty contracts is a very large price to pay while you are learning.

    Open a practice account of $5k, and go at least 6 months until you are consistently profitable. Then gradually increase the account size.
  9. No option broker worth their salt will do that so no worries. If you are assigned on the short call, the short stock is covered completely by the long call and you can simply exercise it if the short is too big to hold. Truly the broker should combine the two in treating it as a synthetic put at a net credit.

    Bottom line, any broker that brings on a marign call or auto-liquidates is a crappy broker. Any option broker out there, even IB will recognize the position and the owner can simply exercise the long call.

  10. rickf


    Oh, no worries -- I would NOT use that much my first time out!
    #10     Apr 3, 2007