Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_4

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Annuities and Other Retirement Products: Designing the Payout Phase (Directions in Development)_4 O ptions spreads 76 P art 2  Table 8.2 Long SPY June 117–119 call spread 115 116 117 117.90 118 119 120 121 SPDR –0.90 ---------------------------------------------------------------- Spread debit 0 0 0.00 0.90 1.00 2.00 2.00 2.00 Value of spread at expiration –0.90 –0.90 –0.90 0.00 0.10 1.10 1.10 1.10 Profit/loss 1.5 1 0.5 0 115 116 117 118 119 120 121 –0.5 –1 Expiration profit/loss relating to Table 8.2 Figure 8.1 *Short call spread Neutral to bearish strategy Suppose you are neutral to bearish on the S&P 500. With 45 days till expiration, June time decay is beginning to accelerate. You would like to collect premium if the index stays in its current range or if it declines, but you don’t want to risk the unlimited loss from a short call. You may then sell the June 117 call at 2.60, and in the same transaction pay 1.70 for the June 119 call, for a net credit of 0.90 Your position is known as the short call spread because it is similar to a short call.4 The advantage of your spread is that it has a built-in stop-loss cover at the higher strike, or 119. You may think of this spread as a potential sale of the stock at 117, and a potential buy of the stock at 119. For this risk, you collect a premium. 4 This spread is also known as the bear call spread and the short vertical call spread. C all spreads and put spreads, or one by one directional spreads 8 77  The expiration profit/loss of this spread is opposite to the above long call spread, but the break-even level is the same. Here, the maximum profit is the credit received from the spread, or 0.90. This profit is earned if the stock is at or below the lower strike, or 117. The maximum loss occurs if the stock is at or above the higher strike. This is calculated as the difference between strike prices minus the income from the spread, or (119 – 117) – 0.90 = 1.10. The break-even level is the same as the long call spread. This is the level at which a loss due to an increase in the stock price matches the income from the spread. The calculation is the lower strike price plus the price of the spread, or 117 + 0.90 = 117.90. Below is a summary of this spread’s expiration profit/loss: Credit from short June 117 call: 2.60 Debit from long June 119 call: –1.70 ––––– Total credit: 0.90 Maximum profit: credit from spread: 0.90 Maximum loss: (difference between strikes) – credit from spread: (119 – 117) – 0.90 = 1.10 Break-even level: lower strike + credit from spread: 117 + 0.90 = 117.90 The risk/return potential from this spread is also opposite to the long call spread, or maximum loss divided by maximum return at 1.10/0.90. Here, a risk of each $110 offers a potential return of $90. Table 8.3 shows the expiration profit/loss for this short call spread. Table 8.3 Short SPY June 117–119 call spread 115 116 117 117.90 118 119 120 121 SPDR 0.90 ------------------------------------------------------------------ Spread credit 0 0 0.00 0.90 1.00 2.00 2.00 2.00 Value of spread at expiration 0.90 0.90 0.90 0.00 –0.10 –1.10 –1.10 –1.10 Profit/loss The expiration profit/loss for this spread is graphed in Figure 8.2. O ptions spreads 78 P art 2  1 0.5 0 115 116 117 118 119 120 121 –0.5 –1 –1.5 Expiration profit/loss relating to Table 8.3 Figure 8.2 *Long put spread Bearish strategy The SPDR is currently trading at 115.22, and you are bearish, short term, on the S&P 500 index. You may wish to purchase the June 113 put to profit from a downside move. With 45 days till expiration, time decay is accelerating ...