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How Do I Determine A Spread Price?

Posted by Pete Stolcers on July 5, 2006

Option Trading Question

Today Jackie V. states, “I traded a bull call spread of the Russell 2000. I purchased the 710 Dec Call and sold the 720 Dec call. It is trading @ 730 yet the 710 call has an intrinsic value of $8 and the 720C has an intrinsic value of $9. I don’t get it. I didn’t get a chance to close the position before it passed 720 and now I’m just at a loss.”

Option Trading Answer

There are a couple of issues I need to address before I answer this question. First of all, this index is relatively ill liquid with very wide bid/asks. You will almost always be trading against Specialists/Market Makers. The second is that the spread is made up of options that expire way into the future. The only way a position like this can possibly make sense if if you put it on with the intent of letting it sit for months. The wide bid/asks and similar deltas of both strikes will keep you from making any money on the trade even it you are right short-term. I hate being right and not making money. If you were looking for a short-term move, trade a short-term spread. For more information on this topic, reference my article, “The Problem With Debit Spreads”.

The second issue is the statement that the intrinsic value for the 710 calls is less than the intrinsic value for the 720 calls. By definition that statement can’t be true. With the index at 730, the 710 calls are worth $20 and the 720 calls are worth $10 (general statement assumes no dividend will be paid before expiration). Jackie must be using a last price in her calculation. When the options are ill liquid, only real-time bid/ask comparisons can be made since hours/days might pass between trades.

As for the greater issue, spreads involve two strikes with two bid/asks. How can you tell where the spread is trading? As the spread approaches expiration it will start to trade at parity. If you bought a spread that is now way out of the money, you’ll be able to figure out the prices. The options will be trading at smaller dollar amounts (often under $1) and the options will have somewhat tight markets with $.10 - $.20 wide bid/asks. The more difficult situation is where you are long a deep spread. This is a good thing because you are making money.

Let’s say that you are long the 70 - 75 call spread and the stock is trading at $85 the week these options expire. The 70 calls may be $14.80 x $15.30 and the 75 calls may be $9.90 x 10.30. You look at the screen, and you figure you have to sell the 70’s for $14.80 and buy the 75’s for $10.30 - you will end up with a $4.50 credit. That is not where the spread is trading. When the options go deep, be creative. Look at how much it will cost you to buy the 75 puts. If you do that, you have locked in a $5.00 credit. chances are an option with a week left that is $10 out of the money (75 put) will be trading for $.10. If you buy it, you have effectively closed down the spread. In this case, It’s not worth selling the 70 put because you will only get $.05 for it… big deal. If the stock goes down to $70, the call spread will expire, but the puts you bought will be worth $5. If the stock crashes and goes below $70, you actually have the chance of a big wind fall profit. The point is look at the opposing spread to calculate where the deep spread should be priced. In this case, buying the put would save you $400 on a 10 lot spread. You would have sold the spread for $4.50 and now you have sold it effectively for $4.90 (with a kicker if the stock tanks).

The smarter move in this case might be to let the spread go through exercise/assignment. Every time a $75 call gets assigned, exercise an equal number of 70 calls. You will effectively be selling stock at 75 and buying it at 70. The net result will be selling the spread for the max. $5. If you act (exercise the 70 calls) the same day you were assigned, you will not incur any margin requirements on the short stock (short stock at $75 via assignment of 75 calls you were short). By going through this simple process, you will gain the full $5 and it is an extra $500 compared to getting out at the quoted $4.50 on the screen (not considering commissions). If you are short a spread that has gone “deep”, reference this article, “Exercise, Assignment and Spreads”.

While this article mainly describes exiting long a “deep” spread, the same principle can be used to value a spread when you are entering a trade. Learn spread relationships and understand equivalent positions. 

If you have any expiration related questions, Ask Me. I’ll try to respond.

Option Trading Comments

  • On 05/15, Shawn Johnson said:

    I traded my first Bull Call Spread last month.  I bought 5 calls on POT with a 180 strike and sold 5 calls with a 185 stike. POT is now at 195. Do I need to unwind that trade early or can I let them expire and be automatically exercised and Assigned?

    Any info would be greatly appreciated!

    Thanks!

    Shawn

  • On 05/15, Pete Stolcers said:

    Hi Shawn,

    Congratulations! You won’t have to do a thing if the stock stays above $195. However, the way it moves, that is not a slam dunk. You can take profits and one way to determine where the call spread is trading is to look at the 195 - 185 put spread. Those options have a narrower bid/ask and that debit spread will tell you where you can get out of the call spread. In this case it is trading for a $1.25 debit so you can get out of the call spread for $8.75 credit ($10.00 - $1.25). Don’t get greedy. Here is an article that talks about spreads and assignment.
    http://www.1option.com/index.php/ask_me/comments/exercise_assignment_and_spreads/

    Good luck!

  • On 11/13, Tony Perrin said:

    If the index expires anywhere above 720 your spread will be worth 10.  You could try and get a bid for the spread from a specialist to see what you can trade out of it for now.

  • On 11/13, Pete Stolcers said:

    That is true, just beware of their wide markets. They will stick it to you when ever possible. If a spread is worth $10, they will bid $9.70 for it and you will lose $300 on a 10 lot by using them. If you can wait until expiration, auto excercise/assignment will get you out for the full value. You can also consider buying the 720 put.

  • On 07/17, Tom J said:

    OK, I am confused.  I am currently long 2 bull call spreads on IBM.  AUG 105C/110C.  The stock is currently trading at 114.28.  The best bid on my spread is 4.10.  I don’t understand why the bid is so low.  I submitted a good for day limit/credit order to close the position out at 4.70 and it is sitting there.  Shouldn’t the market maker or specialist accept it because he could arbitrage it for .30 each?  What is a reasonable slippage on this?

  • On 07/17, Pete Stolcers said:

    There is a whole month left before expiration and the stock could easily move back below $110. That is why you can’t get out at $4.70.

    The only arbitrage that would occur if this were a July spread that expires today. Even then the position carries risk, but they would buy the spread for $4.95, knowing it will be worth $5 at the close.

  • On 07/17, Tom J said:

    Yeah, I guess I see it now.  For some reason I was thinking it would be possible to lock in the profit by exercising the long leg to cover the short leg, but you would still be exposed to the risk of the stock price dropping below 105.  I can see I really didn’t understand how time affects the profitability of a vertical spread when I opened this position. (I thought the theta of the two options would cancel.) Well, at least it’s still a net gain overall.  Thanks for the assistance and quick reply.

  • On 06/16, LJ said:

    So if you’re long a spread that is deep in the money, will it trade at parity before it actually expires?  Let’s say that I’m long 20 contracts of a 40/37.5 spread, and the stock has crashed and is trading near $30.  So clearly the spread is deep in the money. The way I see it, I have two options:

    1) let the whole spread expire, and get auto-assigned/exercised.  In this scenario, I get charged two $20 assignment/exercise fees, so I walk away with 20 contracts multiplied by $2.50, less $40 in fees for a total of $4960.

    2) try to close the spread the day before expiration.  This is really where my question is… what are the chances that I’ll actually get full parity for the spread?  If I close the spread, the commissions will be less than the $40 from example 1, and I’ll keep more of the profit (and yes it’s a tiny amount, but it’s really a more general question)…

    the real question is: whether or not I’ll be able to get full parity for a deep spread the day before expiration, or whether I should just let it be assigned/exercised.

  • On 06/20, Pete Stolcers said:

    Great question.

    A Market Maker will not take you out at parity. If there is $2.50 between the strike prices, they might take you out at $2.45. They have to make a nickle at least to provide some incentive. Otherwise, you are asking them to trade $2.50 for $2.50. In your case, the probability of them making the nickle overnight is very high since both strikes are deep in the money. If the stock was at $36.50 the day before, you might only get $2.35 for the spread.

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