Bear Call Credit Spread
The figure below shows the risk/reward graph for a Bear Call Credit Spread on the Russell 2000 index (RUT). This type of trade is called a credit spread because when we, as a seller, open, or sell, this type of trade, we will collect a credit, also called a premium. When this trade expires, and if the RUT stays below the 740 strike price, the credit spread will expire worthless for the buyer, and we as the seller will keep the premium collected, which is about $500 for the trade shown below. In order to create this Bear Call Spread we would open the following two “legs” shown below:
Buy to open, RUT 10 contracts, 750 strike, January 2006 Call
Sell to open, RUT 10 contracts, 740 strike, January 2006 Call
Buy 10, RUT 750 Jan 06 Call
Sell 10, RUT 740 Jan 06 Call
Bull Put Credit Spread
The figure below shows the risk/reward graph for a Bull Put Credit Spread on the Russell 2000 index (RUT). This type of trade is called a credit spread because when we, as a seller, open, or sell, this type of trade, we will collect a credit, also called a premium. When this trade expires, and if the RUT stays above the 610 strike price, the credit spread will expire worthless for the buyer, and we as the seller will keep the premium collected, which is about $500. We would open this credit spread by placing the following order:
Sell 10 contracts, RUT 610 strike, January 2006 Put
Buy 10 contracts, RUT 600 strike, January 2006 Put
Sell 10, RUT 610 Jan 06 Put
Buy 10, RUT 600 Jan 06 Put
Combining two credit spreads to create an Iron Condor
The figure below shows an Iron Condor. This trade is created when we combine both a bull put credit spread and a bear call credit spread. If the Russell 200 Index (RUT) stays above 610 and below 740, called the “safe zone”, for 55 days for this particular example, both spreads will expire worthless for the buyer and we, the seller, will keep the collected premium. Assuming we open quantity 10 of this iron condor, comprising 10 point wide credit spreads, the maintenance requirement would be a total of $10,000. By opening both the bottom bull put spread, and the top bear call spread, we only have to provide maintenance for one side of the trade, thus providing us the opportunity to double our return on investment.
How Implied Volatility (VIX) Can Impact a Trade
Implied Volatility (IV) is a measure of how much the “market place” expects the price of an underlying stock or index to move; i.e. the volatility that the market itself is implying for the underlying stock or index. The VIX index represents the Implied Volatility for the S&P 500 index (SPX), therefore giving us a prediction of the potential size of future price swings for the SPX. Wall Street, in general, uses the VIX to represent the volatility of the stock market as a whole, and not just the SPX. One of the variables of pricing an option is IV. Thus, when IV for an underlying stock or index increases, the price of options on that stock or index increases. Conversely, when IV for an underlying stock or index drops the price of options on that stock or index decreases. For traders like us who write (sell) index credit spreads and iron condors, we like higher IV because we can collect more premium for the options that we write.
Implied Volatility (IV) is also called the fear index. When the market goes down the VIX goes up – i.e. investors are getting more fearful. On the contrary, when the market rallies, IV drops and fear subsides because investors start feeling more comfortable with the market. Therefore, there is an inverse relationship between the underlying index or stock and its IV. Figure 1 shown below demonstrates the inverse relationship of the Russell 2000 index (RUT) to the VIX. As you can see, when the RUT sells-off, investors get more fearful and the VIX climbs; and when the RUT rallies, investors feel more comfortable with the market and the VIX subsides.
What are the risks when the underlying index climbs right up to our short call leg in the last few days before expiration?
This case study analyzes what happens to a credit spread and its associated risk/reward graph when the underlying index surges in the last week just before expiration.
How to read an options risk/reward graph
Below are example risk/reward graphs showing 1 contract of the RUT Aug ’07 760/770 bull put spread. The first graph shows the RUT Aug ’07 760/770 bull put spread with 37 days until expiration. The next graph shows the risk/reward graph for the same trade 14 days until expiration. The third graph shows the risk/reward graph for the same trade 2 days until expiration.
Because there are 10 points between the leg sold and the leg bought, this trade is classified as a 10 point wide credit spread. In order to open this trade the broker will require and hold $1000 of maintenance.
The right X-axis of the graph below represents the gain or loss of this bull put credit spread. The maximum potential loss is $920 ($1000 of required maintenance held by the broker less $80 of premium collected when we first opened the trade), and the maximum potential gain of this trade is $80 representing the credit collected when we first opened the trade. The long, thin arrow is pointing to the credit of $80 that is collected when the trade is first opened. If the SPX stays above 770 through expiration then we, the seller, will keep the $80 credit. The left Y-axis represents the price of the underlying index, in this case the RUT. The left X-axis represents time showing the chart of the closing values of the RUT index from April 2006 through July 2007. The black horizontal line represents the closing value of the RUT index; for the first graph the RUT closed at 837.48 on 7/10/07, the date shown at the bottom of the graph. The colored lines help us calculate the value of the option trade as a function of time to expiration and a function of the price of the RUT index. For example, the first graph shows the red, blue, green and black lines that can calculate the values of the option trade, as a function of the price of the RUT index, at 37 days, 25 days, 13 days and 0 days until expiration. Continuing with this example using the first graph, at 37 day until expiration, using the red line, the RUT closed at 837.48, showing us that the value of the option trade is approximately negative $85. That is, the trade is drawn down by $85, which represents an unrealized loss, at 37 days until expiration.