In this week’s Coaches Mailbag, I answer a question from Matt H, in Hawaii, about his vertical credit spreads. A common point of confusion on cash flow trading, is how, where and when does a trade make or lose money. First read his question below, then my answer and explanation. If you want to be featured in an upcoming Coaches Mailbag, send us a question to email@example.com and we’ll take the best ones and answer them either in our blog or on our podcast.
In my paper trading account I have the below positions with AMZN (bear call spread) and ALXN (bull put spread).
– STO (9) AMZN Nov 1060/1055 Bear Call Spread @ .70 net credit; delta higher strike .16; 5$ spread; max gain if AMZN < 1055 @ expiration (graph attached below).
– STO (9) ALXN Nov 125/120 Bull Put Spread @ .59 net credit, delta higher strike .16; $5 spread; max gain ALXN > 125 @ expiration (graph attached below).
With the Bear Call Spread, my understanding is the ultimate goal and max gain occurs when the price of the stock stays below the lower strike call through expiration. And conversely, with the Bull Put Spread, the ultimate goal and max gain is received when the price of the stock remains above the higher strike at expiration.
In both respective cases, even though the market price remains in what I perceive to be profitable territory (below or above the respective strike req’d for max gain), I’m showing an overall loss in both cases (shown in the attachment below). I’m less worried about the loss and more concerned I’m missing a key concept across both of these spreads.
Aloha, and thanks for your question. There are many things that jump out at me regarding your question, so let me list a few bullet points that we need to discuss to help you better understand your strategy.
- Vertical Credit Spread philosophy
- Vertical Credit Spread management and expectations
- TOS Position Statement
- At Expiration vs. Current Date expectations + Risk Profiles
- Resources to help you learn more about the topic
The first thing I would tell you, is great job! I know you’re putting the leg work in to develop as a trader when I see your progress. Just a few months ago, you wouldn’t have been able to ask these advanced questions and that’s a testament to your work that you’ve put into your courses.
When trading a Bull Put or Bear Call spread, the trades are designated as ‘Cash Flow’ trades because they are theta positive and time passing will help the trade. There are other factors that go into their profitability, or loss, between now and expiration though. Yes, it is true, that you will make a full profit and realize it in your account if the trades stay below your short strike before expiration. But, no it is not true that you will have a profit throughout the duration of the trade because you are in your profit zone that it needs to be at expiration.
Consider a few scenarios that could create a loss, if you enter a Bull Put spread on Monday, and the trade has 30 days until expiration, but during the first week the stock starts dropping rapidly, then you would have a loss in your account now even though it may turn back into a profit as long as it stays above your strike between now and expiration. The same thing will happen with your Bear Call spread. In Thinkorswim, there are advanced calculations that you can add to the option chain called ‘probability of touching’ and ‘probability of expiring’. These will be different measures, because something can go down and touch your short strike and then bounce back up and expire in your max profit zone.
Let me give you a risk profile picture to help you see it….
This is the typical risk profile that a trader builds. It’s called a +1 @ Expiration Risk Graph. That means it has the Blue Line (at expiration) and one specific date line (generally today’s date, but that can be adjusted.) You’ll notice the trade will make and lose money very differently between today and the expiration. So, on any given day, your trade can be losing some $ even though it’s in your profit zone. This is where your management rules must come in.
Now consider this version of a Risk Profile. This is called a Day Step Risk Profile, where you can measure the potential gain and/or loss on 5 different dates in the future. In options trading, you’re not just trying to hit a target, you’re trying to hit a moving target. Yes, with a credit trade, you have a window where you will make money if the stock stays above or below that price at expiration. But, depending on how it behaves between now and then, you may have a gain or a loss, which is where the management rules come in.
You’re reading the position statement correctly, I would refer you to these playlists on the Tackle Trading YouTube channel if you haven’t already seen them:
Hopefully this clears up some of your confusion on that item, and it’s a common question. We’re trained to think ‘At Expiration’ as a new trader to keep it simple, but there are many market variables between now and expiration that impact the price.