Option Trade: DIA Vertical Call Spread for Credit
I’ve talked about the Dow Jones having a hard time reaching and staying above the 8,150 area for a while. This morning after the bad GDP numbers were released the Dow soared and made it above that range. Continuing in my non-believer mindset I checked the options Dow tracking ETF DIA. In an unusual trade for me I eyed the call options. I entered two limit orders and canceled both as I tried to find the sweet spot for my trade. Finally I lowered both my strike and my credit limit.
While DIA was trading at $81.67 my limit order for six 82/83 May vertical call spread hit and I took a $0.48 credit. I sold the May 82 calls (DAVED) for $1.86 and received $1,101.48 and I bought six May 83 calls (DAVEE) for $1.38 and paid $832.50 after commissions. Together that gave me a net credit of $268.98 after commissions.
With $268.98 as my maximum gain, my maximum loss is around $340 with commissions. That’s not a bad risk/reward, especially since my $82 strike call is still out of the money. I don’t expect DIA to make it above $82.00 at all in the next 13 trading days, but if it does I still have a cushion up to the $82.45 area. At that point I’d expect it to dip back down again. If I don’t see DIA falling sooner than later I might consider closing the call spread for a small profit or break even.
I posted a DIA chart just after noon today on my chart blog. Also worth mentioning – Be sure to check out the Carnival of Financial Planning at TheFinancialBlogger.com.
Comment by Joe
Thanks for your blog, it is helpful. I have a question though. If your max reward is 268 and max loss is 340, then your risk/reward is less than 1 which isn’t a good trade (from what I’ve read) Not criticizing just curious. I trade covered calls and naked puts on the 2X and 3X ETF’s and seem to have better risk rewards.
Comment by Alex Fotopoulos
Joe, It’s not a good trade if I was sitting at even money, but my theory that tilted it to the good side was that the call I was selling was out of the money. If I was selling at-the-money I could’ve done better, but the probablility of option assignment on my short call would’ve been higher. I understand your point and don’t enter into many call spreads and even just started with put spreads recently, so I certainly have a lot of room to learn. I almost went with the next strike higher for $0.39, but opted for the higher return, higher risk. We’ll see how this plays out and I’ll learn more as I do with each trade.
I alway appreciate constructive comments. I’ve learned more from y’all than any of you from me most likely.
Comment by mule65
Joe, Can you provide a leveraged ETF example that’s less risky than Alex’s trade? Thanks.
Comment by joe
Bull Put Credit Spread on FAZ (currently $ 8.02) …..I just did a FAZ trade today where I — Buy 10 May 7.5 FAZ Put @ .95 and — Sell 10 May 9 FAZ Put @ 1.95 (Sold Spread for a Credit of $1000 – 20$ commission) Max Profit = $1000, Max Loss = $500
2:1 Risk reward (instead of a $268/$340 = .78 : 1, no disrespect Alex…)
Comment by Alex Fotopoulos
Joe, You have to do a lot worse to offend me. Please explain how your max loss is $500. If FAZ goes down to $6.55 you lose $500 on the short put and you lose all of your $950 on your long put too. That’s $145 per option x 10 which is a $1,450 loss plus $20 commissions.
If FAZ stays at $8.02, you lose as much on the short as you do on the long so you break even. In my trade if DIA stays flat I take a full profit and I have ~$0.75 cushion if it goes up to break even.
Please correct my logic.
Comment by Joe
Alex,
If FAZ = 8.00 then my 7.5 Put that I bought expires worthless, I make $1000 for the premium, I lose $1000 on the 9 Put I sold. BREAKEVEN
If FAZ = 6.50 then I make $1000 on my 7.5 Put that I bought, I make $1000 for the premium, I lose $2500 on the 9 Put I sold. LOSS = $500
If FAZ = 3.00 then I make $4500 on my 7.5 Put that I bought, I make $1000 for the premium, I lose $6000 on the 9 Put I sold. LOSS = $500
If FAZ = 10.00 then 7.5 Put that I bought expires worthless, I make $1000 for the premium, the 9 Put I sold expires worthless. PROFIT = $1000
Since this trade is a Bullish bias, I want FAZ to trade above 8.00 and preferably over 9.00. Anything over $9.00 and I don’t care, I made my max profit of $1000.
Comment by Alex Fotopoulos
I’m with you now. I was mistakenly calling your long 7.50 put a loss when it would actually broke even at $6.50.
The difference then is that the underlying stock in my trade doesn’t have to change in price and even gives me a cushion before I don’t take a full profit. Your underlying stock has to move up some to give you any profit and has to go up $1.00 to give you a full profit.
I agree that yours exposes you to less dollar risk and do you agree that mine exposes me to less probability risk? I could’ve done a lower dollar risk with a call spread on DIA of 80/81, but the probability wouldn’t have been as good for me to take a full profit on it. I prefer higher probability trades.
Comment by Joe
Alex,
I ran your numbers for DIA. I assumed (WAG) a volatility of 50% for DIA for the calulator (Target Volatility). By the way, our trades are similar in style but, it looks like your probability numbers are a little better than mine. (in your case, 73.3% chance you will achieve max profit)
++++++++
*** Position #1 ***
Sell 6 Calls : Strike 82.00 Days 15 at $1.86
Option Volatility = 32.19%
*** Position #2 ***
Buy 6 Calls : Strike 83.00 Days 15 at $1.38
Option Volatility = 31.07%
Credit of $2.88
Max Profit $2.88
Max Risk $-3.12
Upside Breakeven $82.47
Downside Breakeven $82.47
Probability retain Target of 0.00% Max Profit : 96.72%
Probability retain 25% Max Profit : 87.57%
Probability retain 50% Max Profit : 79.03%
Probability retain 75% Max Profit : 75.82%
Probability retain 99% Max Profit : 73.30%
Try this calulator, it is pretty cool. Joe
http://www.volatilitytrading.net/option_position_calculator.htm