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Options give you the right to buy the stock at a future date. Many people don’t even bother to exercise their options. They simply sell their option at a profit. For example, let’s say you purchase this 90 strike price option for 20 cents. If the stock moved up to 95, that 20 cent option is now worth 5. That’s a tremendous profit.
If you were to purchase 10 contracts of that, it would cost you $200. At expiration, if the stock is selling at $95, that option would be worth $5. That’s the difference between these two strike prices. 95 minus 90 is 5. That’s how they value the option.
Because you bought 10 contracts, that option, at $5, is now worth 5,000. A $200 option you purchased today, if the stock was to go up to 95, would be worth $5,000. Most people would not exercise their options to buy the stock, unless that was their goal. They would simply sell the option back to the market for $5, capturing that $4.80 profit.
Why would you sell it? Like I said, on a bull call spread, you hope to be able to have the stock rise past your short strike, until at expiration, you can collect the full profit of that spread, of $5 at expiration. In this case, we’re buying the spread for $2.20. At expiration, that spread will be worth $5, making us a $2.80 profit.
What happens if it doesn’t move? What happens if the stock stays at 75? Well, that $3.75 of intrinsic value in this option, or the $4.10 that we purchased, will be worthless at expiration. We will have lost all $4.10 that we paid for it.
Not only that, but our option that we sold at 80 cents, at the 80 strike price for $1.70, will also be completely worthless. That’s why the maximum loss of a bull call spread is the debit that you paid for it.
We will have actually made a profit of $1.70 on this one, because we sold it. If we can buy it back for 0, we keep the difference as our profit.
In the case of this option, we bought it for $4.10, and we lost the maximum; our $4.10, on this option. We gained $1.70 on that one; we lost $4.10 on that one. Because we’re using retail prices here, that gives us a maximum loss of $2.40. We were trying to hit the mid-price, so our maximum loss is $2.20. The difference is, you lose whatever you paid for the spread.
Now, when we do the opposite, we actually sell the vertical. We collect a credit of $2.15. Now, what happens if the stock stays the same, and it does not move, and it is 75 at expiration?
If it is 75 at expiration, we get to keep the maximum credit that we put this trade on for, which is $2.15. When we go to sell it back, when we go to purchase these options, we’re purchasing back the 75, and we’re selling the 80, we’re selling the spread… We hope to sell it for nothing. Hopefully, we can just let it expire, and we can collect the maximum profit. We know, ahead of time, what our maximum profit is going to be. In this case, it’s $2.15. That’s the most that we can make on this trade.
Our maximum loss is $2.85. How would the maximum loss be achieved? If the stock were to rally up past the 75, and close above 80, which is the price at our long call, then this spread will be worth 5, and we will have made our maximum loss, which is $2.85. The reason for this is 2.15 minus the difference in the strike price is $2.85. That’s our maximum loss.
Why would we sell, rather than buy, these spreads? I’ll show you. Let’s right click on this order dialog box and go to “Analyze duplicate trade.” Let’s take a look at this. When we sell a spread, we manage our business based on the numbers. When we receive credits on a spread order, because we’re selling an option that is more expensive than the one we’re buying, we’re going to have a negative Delta.
Remember, when you buy a call option, you will have a positive Delta. When you sell a call option, you will have a negative Delta. In this case, we sold one that was more expensive than the one we bought. We like to buy low, sell high. That’s what all good business do.
We will have a negative Delta. More importantly, we will have a positive Theta. In this case, $1.08. This means that, as time progresses, as we get closer and closer to expiration, we would hope to achieve a $1.08 profit, every single day that we hold this position – given that prices will hold relatively stable.