A call option buyer expects, or hopes, that the share price of a company will rise by a certain amount within a specified time frame. For the right to lock in to a price agreed upon today, he pays the contract seller a fixed amount known as a premium. If the call option expires in the money, through a process known as exercise, the call buyer may exercise his right to purchase the shares of stock specified by the contract. Alternatively the call buyer may sell the option contract at the prevailing market price.<\/p>\n
Whether or not he makes a profit depends on the current market price of the underlying shares, the amount of the premium paid, as well as any commissions or fees. As we did in the first video, in calculating breakeven points, we\u2019ll disregard the cost of commissions for simplicity, but please
\nremember that commissions are an added cost and should be considered when calculating breakeven points. Information on commissions and fees can be found on the IB website.<\/p>\n
A call option provides the buyer with a fixed cost with potentially unlimited upside should the share price increase.<\/strong><\/p>\n Conversely, an investor may be bearish on a stock and could buy a put option giving him the right to sell a specified number of shares by expiration at a price agreed upon today. Once again, the current market price of the underlying shares, the amount of premium paid by buyer to seller and the cost of commissions and fees can have an impact on whether the tactic is profitable.<\/p>\n A put option provides the buyer with a fixed price at which to sell the underlying stock (the strike price).<\/strong> The maximum risk is the cost of the put option (the premium) should it expire unexercised, which would occur if the underlying share price increases beyond the strike price of the option.<\/p>\n Vertical spreads<\/strong> – In order to increase the likelihood of being profitable, some investors use spreads to reduce the impact of premiums on P&L. Let\u2019s walk through a theoretical example to make the point.<\/p>\n Let\u2019s assume that shares in company XYZ Corp. are trading at $66.50, and that a 90-day call option with a strike of $70.00 costs $1.00. And that a call option with a strike of $75.00 at the same expiration costs 50 cents. It is important to note that multiple leg strategies, including spreads, will incur multiple commission charges.<\/p>\n Moderately bullish<\/strong> – An investor is moderately bullish on the short-term prospects of the stock and expects it to rise by the time options expire by more than 10%. In order to reach the $70 strike, the shares must rise by 5.2%. In order to reach the $75 strike, its shares must rise by almost 13%. Compare the performance profile of the two options.<\/strong><\/p>\n The investor is now faced with deciding which option is most likely to pay off in the event that he is right. Of course, if the share price does not rise to at least the lower strike price plus the premium paid, in either case he\u2019d lose the premium paid. Alternatively, he could look at the trading opportunity The call spread or a vertical spread – He could buy the $70 strike, paying $1.00 and SELL the $75 strike and receive the 50 cent premium. This leaves him bullish at prices between $70-75, but bearish at prices above $75. Netting the two premiums means that he now pays just 50 cents in order to get bullish above the $70 strike price and so his breakeven is now only $70.50 rather than $71.00. The pitfall here is that his bullish rights above $70 are offset at any price above $75. However, if you recall, he\u2019s moderately bullish and has reasonable expectations.<\/p>\n This is known as a call spread or a vertical spread. Because there is a net cost, it is also known as a debit spread and is a common trading strategy among option traders who are modestly bullish and want to reduce the cost of upside exposure.<\/p>\n Moderately bearish<\/strong> – On the flip side of this strategy, a modestly bearish investor might buy a put option with a strike below the prevailing trading price of a stock and sell another put option whose strike price \u2013 and premium – is lower than that of the put option he bought. This exposes the investor to Profit and loss<\/strong> – For debit spreads, the P&L calculations are straight forward. For buying call positions we added the premium to the strike price to show the breakeven point. For buying puts, we subtract the premium from the strike price to calculate the breakeven price. We still follow that process with the net cost for spreads, but we need to make another calculation. For the call spread, the distance between the strikes is $5.00 \u2013 that\u2019s the 75 strike less the 70 strike.<\/p>\n One way to visualize the profile for a vertical spread is to split the distance between the strikes between a cost and potential profit. If the spread is $5.00 between the two strike prices and the net premium is 50 cents, the breakeven is the lower strike of $70 plus the premium to give a breakeven of $70.50. If the trade has a maximum 50 cent loss, the remaining $4.50 is potential profit. And the maximum potential profit occurs at the upper strike price of $75, which is also where the long position is entirely offset by the obligations of the short position. That\u2019s why the performance profile displays two horizontal lines. The first to the left of the lower $70 strike represents the fixed cost or loss of the trade of 50 cents. The upward sloping line joins the other horizontal at the upper strike of $75 where the initial call purchase is offset by obligations from the sale of the higher strike option. Because there is a $5 distance between the two, this is the most the investor could make from this trade MINUS the cost of getting the position on \u2013 that was, of course, 50 cents.<\/p>\n Adding vertical spreads to Mosaic<\/strong> \u2013 So let\u2019s learn how to create some vertical spreads in Mosaic and add them to the order tab or a watch list. It is also easy to analyze scenarios using the Performance Profile.<\/p>\n For the purpose of illustrating a vertical spread, let\u2019s use this watch list in Mosaic, which already monitors shares in Apple \u2013 ticker AAPL. Let\u2019s add the options combination to a new line in order to view its current status, historic movement and have it accessible should we wish to trade it at some point. This opens the Combo Selection tool, prepopulated with option data for the underlying. Stay on the first tab, named Multiple, and use the Strategy selection menu to locate the Vertical Spread.<\/p>\n In this case we are going to create a $10-wide spread using call options with a January 2018 expiration. As those filters are applied using the boxes on the left of the Combo Selection tool, more data is eliminated from the search. Click on the month, the Call selection and click on 10 for point Let\u2019s run through the same exercise for this ticker for a vertical put spread. Once again we will Because Mosaic is color-linked, clicking on either spread will enable us to populate the chart. For best Strategy Builder<\/strong> – Here is another way of adding a combination to your page. Input the underlying ticker If you add multiple spreads or have other orders, this window can become quite busy. When an open Chart entry<\/strong> – Saved combinations also appear in the Orders panel beneath the chart. This can be Performance profile<\/strong> \u2013 the Performance profile window can be accessed from the blue new window Once you get used to the basic concept behind equal ratio debit spreads and can quickly identify the at This lesson brings the concepts together to illustrate the benefits of combining single option trades into complex
\nAnd so, if the investor paid $1.00 for the right to buy shares at $70 at or before expiration, because the breakeven price is calculated by adding the cost of the premium to the strike price, the shares must rise to $71 or 6.7%. Likewise, in order to reach breakeven at the $75 strike, its shares must rise by that additional 50 cent premium or by 13.5%.<\/p>\n
\ndifferently. Remember, he is looking for an upswing that would carry the stock above that $70 strike, but he\u2019s not assuming that the rally is without its limit.<\/p>\n
\nprofits in the event that the share price falls below the strike price of the purchased option by expiration. Remember that the investor has selling rights at the higher put strike of the option that he purchased, but has offsetting obligations at the lower strike price of the option that he sold.<\/p>\n
\nInput the ticker symbol in the watch list and select Combinations from the dropdown menu and follow Option Combinations (SMART).<\/p>\n
\nspread and then select the lower buy strike you wish to use. This automatically isolates the only possible combination in the box on the right. Highlight the line and click Add from below. In order to also add quotes for both legs to the watch list, check the box in the lower left of the tool. The default input shows a buy\/sell ratio of 1:1. However, ratio spreads involving the sale of multiple higher strike call options is also common amongst option traders. By taking in multiple premiums at the farther strike further a trader can reduce the overall cost of the trade. However, it increases the associated risk of the trade and you should examine the Performance Profile to see how this might impact your trading. Click OK and you will see the legs of the trade beneath the quote for the combination. Typically, if part of the bid\/ask display is missing for either leg of the combination, TWS is unable to display a quote.<\/p>\n
\ndemonstrate a January expiration using a 10-point wide spread. Input the ticker in the watch list, follow
\nthe Combination line and select Option Combinations. Make the selections from the Strategy menu and
\ncreate the spread from the boxes to the left, remembering this time to select Put. When you have
\nnarrowed down the choice to the single vertical spread desired, highlight the line and click Apply and
\nOK. The spread now appears in the watch list.<\/p>\n
\nviewing of a combination spread, select Max Line from the time period selection in the chart toolbar.
\nThis displays the dynamic price of the spread, which you can relate to the price of the underlying ticker
\nover time.<\/p>\n
\nin the Order Entry panel. To the right, use the dropdown menu to select the Strategy Builder. This leaves
\nthe quote for the underlying intact in the order entry panel but also displays a quote panel and option
\nchain. Use the option chain to select the desired expiration. And then click on the bid and ask prices for
\nthe options you want to combine. Remember, for vertical call option spreads we are buying the lower
\nand more expensive strike, and selling the higher less costly strike. Input the number of contracts to
\ntrade and modify the price if necessary. To add this to your Orders panel in the Activity window, click on
\nthe Advanced \u2018+\u2019 sign and click Save. You can add more spread orders to this tab by repeating the
\nprocess. If not displayed, access the order panel by clicking on the \u2018+\u2019 button to the right of the Activity
\npanel. Orders can be transmitted from this panel by clicking on the blue submit button to the right. You
\ncan now click on any saved spread to tailor an order in the Order panel or by entering a new trade from
\nthe Order Entry window in the top left of Mosaic. Open orders can be modified or cancellation
\nrequested for existing orders using the right-click menu, or clicking the grey Cancel button to the right of
\nthe order line.<\/p>\n
\norder is cancelled, the display turns grey rather than deleting the item. That way you can come back to it
\nif necessary. Use the filter to the right on the toolbar to filter the display for just Live orders for fast
\naccess, or you can review Cancelled or Completed by selecting from the menu. One final note \u2013
\nremember that these are Orders, and may be day orders. Day orders will expire and disappear from the
\nActivity panel if unfilled by the end of trading and will not appear upon reopening TWS. You may want to
\nconsider adding your favorite or commonly-traded combinations to a watch list to track and save these
\nitems.<\/p>\n
\ndisplayed using the increase\/decrease arrows beneath the chart and again, orders can be created and
\nmodified from here.<\/p>\n
\nbutton and locating the Option Analysis directory beneath Option Analytics. You could also embed the
\nprofile window in Mosaic or you can build and save a whole page devoted to options, if you wish.
\nClicking on any of the spreads in either a Watch list or from the Order panel, will display the spread. Any
\nof the equal ratio combinations we have so far referred to in this video will have the same profile. The
\ndifference will be determined by the spread between strike prices, the premium paid for the
\ncombination, the remaining time value and the implied volatility. Remember that the distance between
\nthe strike prices will always be either fixed cost or potential profit. For call spreads, the maximum gain is
\nat the upper strike price and is the spread distance minus the net premium paid. For put spreads, the
\nmaximum gain is at the lower strike price and is the spread distance minus the net premium paid.<\/p>\n
\nexpiration profile associated with them, try manipulating the ratio to see how the risk profile changes.
\nBut remember that selling more options than you are buying might reduce the outlay of the trade, but
\nimposes greater obligations and potential losses if the trade plan doesn\u2019t turn out as you had planned.
\nUse the Performance profile to analyze your trading risks in advance and take full advantage of IB\u2019s
\nrange of free trading tools.<\/p>\n","protected":false},"excerpt":{"rendered":"
\noption strategies. Students will learn to easily identify potential profit and loss regions on the Performance Graph and understand how to configure the plot to view P&L and risk measures across different time horizons.<\/p>\n","protected":false},"author":1,"featured_media":221486,"parent":0,"comment_status":"open","ping_status":"open","template":"","meta":{"_acf_changed":false,"footnotes":""},"contributors-categories":[13576],"traders-academy":[13126,13128,13132],"class_list":{"0":"post-175542","1":"trading-lessons","2":"type-trading-lessons","3":"status-publish","4":"has-post-thumbnail","6":"contributors-categories-interactive-brokers","7":"traders-academy-intermediate-trading","8":"traders-academy-level","9":"traders-academy-trading-lesson"},"pp_statuses_selecting_workflow":false,"pp_workflow_action":"current","pp_status_selection":"publish","acf":[],"yoast_head":"\n