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.
The graph below shows that the RUT has declined and closed at 784, fourteen days until expiration. The unrealized loss of the spread is now -$220. The red line on this graph represents 14 days until expiration. Based on the slope of the red line we can see that the loss of this trade will accelerate as the RUT continues to move lower. The thin, long black arrow points to the maximum that can be lost ($920) if the RUT should continue to decline and end up below 760 after expiration.
The graph below shows the volatile nature of the trade at 2 days until expiration. The main characteristic to notice is that if the RUT moves up and down a lot during the last few days before expiration, and if the RUT is near the 760 to 770 range, we are at tremendous risk of incurring a 100% loss on the trade. Note how the price of the option moves more dramatically (right X axis) to small moves in the RUT (left Y axis) based on the slope of the curve when we are down to the last few days of the trade. If the RUT is in the 760 to 770 range, the value of the trade ranges from a gain of $80 (100% profitable) to a loss of $920 (100% loss of maintenance). Thus, if we get down to the last few days of a trade and if the underlying index is Near, At, or In-the-money, we need to close out the spread and roll into a new trade to avert a possible 100% loss of the held maintenance.