Bullish call option spreads

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Gwyde's picture
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Bullish call option spreads

A few quotes, at first on :

Time value

Speculators familiar with buying options know it too well: an option value erodes over time as the stock stays level. The option value is composed of two components:
·         Intrinsic value (for a call option above strike or a put option below strike)
·         Time value
While the intrinsic value only depends on the option strike and the share price, time value is a different animal. It is larger for a stock that is most likely to end up ‘in the money’. Hence the time premium is higher the more of the following clauses are fulfilled:
·         the stock price is pretty close to the strike (the option is ‘near the money’),
·         the option has some time left for the stock to pass the strike price,
·         the underlying exhibits a high volatility, making it more likely for the stock to bridge the gap to the strike price.
Option writers generally take advantage of the time value of their written positions quickly eroding. The rate by which the option value is eroding is defined by the Greek Theta (q). It is expressed in currency per trading day, usually in USD per day, sometimes expressed in cts/day.
The amount by which an option price changes relative to the change of the underlying stock is represented by the Greek delta (δ or Δ, the latter is capital delta). If  δ = 0.30, the option is to appreciate by $0.30 for a $1 rise of the stock. For put options, δ is negative. The nice thing about the Greeks δ and q is additivity. Two call options with different strikes have different δ and q. If you’re long one contract of two options (labelled 1 and 2), the combined (δ, q) = (δ1 + δ2,  q1 + q2).
and more:
Option spreads quenching theta
A bullish call spread consists in buying an ‘in the money’ call option and selling simultaneously an ‘out the money’ call option with the same expiry date. You would preferably choose a quarterly option (or a yearly leap) which has plenty of time left before expiry. Your investment equals the price difference between the bought call and the written call. It also is the total ‘value at risk’.
For the two Greeks of that spread we obtain: (δ, q) = (δ1 - δ2,  q1 - q2). The expensive ITM call has an intrinsice value equal to (share price – strike). Its time value is (option price – (share price – strike)). The out-the-money written call is all time value. You notice that the combined q is the difference of the two q’s of the components long (bought) and short (written). Depending on how you choose the strike levels relative to the current stock price, the combined q can be around 0 or even slightly negative: an option spread has a weak time dependency. The time value loss of the ITM call is compensated by that of the OTM written call.
Edited by admin on 11/08/2014 - 06:16



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