As we enter week 5 of our series on debit spreads, we need to discuss possible adjustments, considering this Friday is March option expiration. Initially, we entered a mock trade on the S&P SPDRs (SPY) using a bull call spread. However, last week we showed a possible adjustment that could be used to protect the trade if the SPY declined in the short term. This adjustment used March options, so they would need to be taken care of by expiration on Friday. As promised, I will continue to track both the initial debit spread and the adjustment we made on March 8.

Before we dive into the data from these trades, let’s quickly review the strategy and my thinking process for the adjustment. A bull call spread is a strategy that benefits from a move higher in a stock, though we usually are not looking for huge moves. The idea is that by using a debit spread, we are lowering our risk. We used the SPY in our mock trade because it was on a nice uptrend and it isn’t as volatile as individual stocks. We bought plenty of time, using the May options and below is the data for this mock trade:

March 1, 2010
SPY @ 111.89
Buy 1 May 114 Call @ 2.53 (IV-17.0)
Sell 1 May 119 Call @ 0.85 (IV-15.3)
Debit to Enter - $168.00
Max Profit - $332.00
Breakeven - $115.68

March 8, 2010
SPY @ 114.27
Long 1 May 114 Call @ 3.35 (IV-16.4)
Short 1 May 119 Call @ 1.19 (IV-14.6)
Debit to Enter - $168.00
Max Profit - $332.00
Breakeven - $115.68
Current Profit - $48.00

March 15, 2010
SPY @ 115.49
Long 1 May 114 Call @ 4.09 (IV-17.6)
Short 1 May 119 Call @ 1.62 (IV-15.7)
Debit to Enter - $168.00
Max Profit - $332.00
Breakeven - $115.68
Current Profit - $80.00

 

Figure 1: Risk Data and Graph for SPY Bull Call Spread
click here for larger view

This mock trade is showing an $80 profit, but the stock market has been very quiet of late with volumes on the light side. The fact is that the SPX is at resistance near $115 and unless some positive news is released, this area could create some selling. This was our thinking last week when the CBOE Market Volatility Index (VIX) hit support, which led to selling back in January. Due to these worries, we discussed an adjustment that would benefit the trade if we did see profit taking, while maintaining our ability to profit on further gains. Below is the data for this trade adjustment:

March 8, 2010
SPY @ 114.27
Buy 1 March 114 Call @ 1.22 (IV-13.9)
Sell 1 March 109 Call @ 5.30 (IV-16.6)
Short 1 May 119 Call @ 0.85 (IV-14.5)
Long 1 May 114 Call @ 2.53 (IV-16.3)
Total Credit - $240
Current Profit - $48
Max Profit - $328
Max Risk - $57

March 15, 2010
SPY @ 115.49
Long 1 March 114 Call @ 1.73 (IV-16.6)
Short 1 March 109 Call @ 6.53 (IV-31.0)
Short 1 May 119 Call @ 1.62 (IV-15.7)
Long 1 May 114 Call @ 4.09 (IV-17.6)
Total Credit - $241
Current Profit - $10
Max Profit - $340
Max Risk - $49

 
 

Figure 2: Risk Data and Graph for Adjusted Trade

Obviously, this adjustment has not benefited us as far as profits are concerned, but we did protect ourselves. We still could see some declines before Friday’s close, but most likely, we will need to close out the adjustment. On Friday, if the March options are still in the money or close, we need to close them out. We do this by buying back the short call and selling the long call.

Still there are risks that could push stocks lower, but regardless of where the March options move, we would want to close them out by Friday’s close. The FOMC meeting Tuesday could impact trading, especially if the Fed makes comments that point to rate hikes sooner rather than later. We will discuss other possible adjustments next week after March expiration, but after Friday, we will be back to a straight debit spread strategy.

I would like to answer a question I got on my forum about the adjustment. The max risk is shown as $49.45 currently for the adjusted trade. A reader asked how we got this figure and this is a good question. Fortunately, we can get this information from Platinum, which has the ability to quickly calculate this information. As one might have noticed, this number and the max profit figure changes, which has to do with implied volatility. The fact that we are trading both March and May options makes the calculation and risk graph a bit tricky. The Platinum graph shows data as of the expiration of the first options. Therefore, when March expiration hits, the total value of the trade can be much different depending on the IV of the May options.

Jody Osborne
Senior Writer & Options Strategist

Optionetics.com ~ Your Options Education Site

Questions for Jody? Please visit his forum through our "Ask the Traders" column on the Optionetics.com homepage.