Options Question: Max Risk

Discussion in 'Options' started by CPTrader, Oct 19, 2008.

  1. A basic question: If in an option spread position is constructed at a debit, i.e. you outlay premium to put on the spread, is your maximum risk always limited to the premiuum paid/ i.e. the initial debit?
  2. spindr0


    No, there are spreads where the maximum loss can be greater than the initial debit cost.
  3. Please share some examples. Thank you.
  4. taowave


    Please enlighten me....

    I am guessing you are heading down the path of dividend risk,premature assignment etc..Do tell

  5. MTE


    The obvious example is a 1x2 ratio spread (buy 1, sell 2). The premium on the 2 shorts may not be enough to cover the long hence you have a net debit to open the position, but the max loss is unlimited (well, for calls it is unlimited, for puts it's substantial).
  6. So how can one determine ab initio his max risk; especially for a somewhat odd spread position e.g. an iron condor with wide strikes in an odd ratio say 3X1?/
  7. spindr0


    Among other possibilities, if you diagonalize a bearish call spread and make the OTM strike the distant month, it can be for a debit and the loss can exceed the debit (debit paid plus the difference in strikes, if driven to parity by a big move).

    Combine that with the mirror image on the put side and you end up with an Iron Condor (diagonalized), a familiar local strategy.

    OK, I do telled.
  8. spindr0


    On an expiration basis, it's fairly easy. If they're all from the same month, all options are zero if OTM, intrinsic value if ITM. You can set it up in a spreadsheet or use an option charting program.

    If any legs are diagonalized, it's a bit more complex as you'll need an option pricing model (program, spreadsheet) and you'll have to guestimate the future IV since at near term expiration, the far months will most likely have remaining time premium.
  9. At this point it is very important to read the GOOG thread in the link above to understand the risk of an OTM option drifting into ITM - even by a nickle - during AH on Friday at expiration.

    Most websites and books that mention a Call Debt Spread state that the Maximum Loss Potential is Net Debit , when in fact that is not true. In the GOOG example if the position was a Call Debt Spread the loss would have been: Net Debit plus $10,0000.
    #10     Oct 19, 2008