Wednesday, October 7, 2009

Playing with Semis

To exploit the expected neutral to bearish move in SMH, suppose we want to sell an OTM call spread. In choosing which strikes to use I usually go as far OTM as possible while still receiving sufficient credit. My target is usually in the neighborhood of a 15% return. For SMH, the November 27-30 call spread seems to be the right fit for me.

Sell Nov 27 call for $45
Buy Nov 30 call for $.05
Net Credit = $.40
Max Risk = $2.60
ROI = $.40/$2.60 = 15%


[Source: EduTrader]

Let's tackle a few potential questions:

Why a $3 spread? why not a $4 (27-31) or $5 (27-32) spread?

Remember, wider spreads have more potential risk, so if I'm going to widen the spread between the strikes I need to make sure I'm justly compensated. Had I bought the 31 call instead of the 30, I would have only increased the net credit by about $.03. Is it worth increasing my risk by $1.00 if all I bring in is another $.03 of premium? Absolutely not! Now, using the same rationale I may have considered doing a $2 spread (27-29) instead of the $3 spread I highlighted (27-30). It comes down to personal preference and risk tolerance. Bottom line- if you're going to widen the spread between strikes make sure it's worth it!

Why November? Why not use October or December expiration?

Given that October expiration is next weekend, there isn't sufficient premium in Oct. OTM calls to make it worthwhile. In addition I prefer to avoid holding options close to expiration if I can avoid it. This helps to minimize the gamma risk in the trade.
I also prefer the higher rate of time decay inherent with November options vs. December.

For other call spread posts, check out:

8 comments:

semuren said...

Greetings Tyler:

How do you plan to manage this trade? Will you hedge with the underlying or with options if it starts to go against you? At what point?

You asked my about why I was thinking of a $2 spread, and why so close to the money on the USO yesterday. When I see your set up here it makes the answer clearer to me. I just could not take a trade with this risk reward ratio. So if I do a vertical on only one side I need to go closer to the money and have the spread tighter.

Thanks for the post and good luck with the trade.

Tyler Craig said...

Semuren,

I've got about four potential techniques I use for managing call spreads the move adversely:

1. Exit if stock breaks above resistance ($26.20 ish on SMH)
2. Delta hedge if stock breaks above resistance. I usually use daily resistance although you could use a smaller time frame if you wanted to hedge quicker.
3. Roll further OTM
4. Simply exit the trade.

AS far as profit target, I'll look to exit the spread when I've achieved about 80% of potential profit.

Anonymous said...

A 15% risk reward seems kind of low to me. Is that what one would typically target for these spreads (how about for calendars, condors, etc.)?

Tyler Craig said...

Anonymous-

Good Questions. Keep in mind there is not a typical target for ANY spread. It comes down to personal preference and risk tolerance. I personally won't accept much less than 15% on a vertical spread. By going far OTM, it raises my probability of profit. So a trader who wants a 30% return would have to use closer to the money options thereby leaving them with a lower probability of profit.

I don't trade calendars that often so you'll be ill served if I give you a profit target on that one.

As for condors, I don't usually accept much less than 15% as well.

One of these days I'll do a post highlighting the trade off of risk-reward and prob. of profit for vertical spreads.

semuren said...

Greetings Tyler:

As always, thanks for the time and effort you spend on the blog.

Starting with your post on probability of profit today I went looking through prior posts for more information on delta hedging. While you seemed like you were going to write about this as part of the series on fixed delta vs variable delta (i.e. options have gamma, stocks don't) I felt like you never got to a discussion of actual delta hedging. Now maybe I just didn't find it, being lazy.

So, if you have more of discussion of delta hedging please and could point me to it I would be most grateful.

A couple follow up questions:

If you exit at 80% of the credit does this number factor into the spread selection? Since you put this on for 15% max ROI but will really get more like 12% (before slippage?)if you exit at 80% of credit collected ROI number are you looking at when you put it on?

A few more on delta hedging. What do you mean by "daily resistance"? Resistance on the daily chart? Or intra-day resistance?

If you delta hedge - I am assuming that you are using the underlying here - when do you take the hedge off? Do you have a stop out for the hedge? Do you leave it on overnight?

Finally, why would you exit vs. delta hedge? Is this just based on a max loss on the initial spread being hit?

Tyler Craig said...

Semuren- I'll tackle your questions this weekend or Monday when I get a chance.

semuren said...

Thanks. Sorry for asking so much, but think of it as a compliment on the value of the content you post.

Tyler Craig said...

Semuren- I posted the response to your questions in my new Mail Time Post.