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If we take a look at this profit picture, this is a graph of this particular spread. The profit picture gives us two lines, by default. One line, the green line, is what our maximum loss, and our maximum profit, would be at the expiration of this spread. The current price is right here, at $75.20.
You can see that as soon as we put this position on, we have a small loss. That has to do with the fact that there is the difference between the natural price and the mid-price. Every time you put on one of these positions, you’re going to have a small loss, as soon as you put it on. The market makers have to make a profit somewhere. That’s where they do it; on the spreads.
If the price moves in the direction that we anticipate, and it goes down, we will make profits. This is because these options will become less valuable, and we will achieve a greater profit.
If the stock were to move up, since the one that we sold was more expensive than the one that we bought, we would be in a losing position. If the price of the stock continues to go up, our spread will lose money, until we have reached our maximum loss, of $285.
With the sale of a vertical spread, we get positive Theta. Theta is the decay of the option over time, that progresses until expiration. Theta will increase in time, as we get closer to expiration. What happens if the price of the stock does not move, though, and it stays exactly the same?
If you take a look at the graph, if we keep this spread on until expiration, we will achieve a $195 profit, which is right up here. That’s one of the advantages of selling a vertical spread. The stock either goes in the direction, or it can stay the same, and we still achieve a very nice profit. We have two opportunities to profit.
Remember, a stock can only go down, it can go up, or it can stay the same. In our case, we win 2 out of 3 times. 2 out of 3 chances, because if it stays the same, or if it goes in the direction we want it to, we profit. The only thing we don’t do is profit when it goes in one direction: Up.
Now, let’s take a look at a regular vertical spread; the purchase of a vertical spread. Let’s buy this vertical spread, and then analyze it on the same graph. It is exactly the opposite picture of the one that we just had up, in which we sold a vertical spread.
Instead of a negative Delta, we now have a positive Delta. It’s positive because the one that we bought is more expensive than the one that we sold. In reality, each one of these options has its own Delta. Since we’re long an expensive option, and we’re short a cheaper option, the positive Delta that we get from the 75 call is subtracted from the Delta of the negative call; the call that we sold short. This creates a positive Delta.
Because we have a positive Delta, we also have a negative Theta. Remember, there were two scenarios in which we could make profit when we sold a vertical spread. If the price stayed the same, we profited, and if it went in the direction we wanted it to, which was down, we profited. 2 out of 3 scenarios, we profit.
In this case, when we buy a vertical spread, the only possible profit potential that we have, is if the price of the stock moves up. In fact, not only does it have to move up, but it would have to move up fairly significantly. To achieve the minimum, it would have to go up to achieve our maximum profit, would be $80, right here. After $80, we continue to receive our maximum profit. In order for it to achieve the maximum profit, it has to rise by $5 before the expiration date.
It has to do something. If the stock just stayed the same, at the same price, we would lose almost our entire investment. Or if it went down, against the direction we hoped it would go, we would also lose our maximum investment.
That’s the difference between the sale of a vertical spread, and the purchase of a vertical spread. They’re only two options in here, and they give you a different profit scenario. The profit scenario for a sale of a vertical spread, is that if the stock stayed the same or went in our direction, we profit. The only way we would lose, is if it goes against us, in direction. Again, the Delta would be a negative figure, and our Theta would be positive.
For the majority of the trades that we’re making, we want positive Theta. We want Theta to be positive at all times. If Theta is not positive, then it gives us a sign that we should probably exit our trades, or put on other trades that would give us a positive Theta.
Why positive Theta? Remember, there’s only two truths to the market. Number one: Prices will fluctuate. Number two: All options expire.
On the whole, if Theta is positive, and we go toward expiration, we will collect more and more of the time value of that option, to our account.