My last post (Part I of this same topic) discussed debit spreads and credit spreads, both members of the vertical spread family. It was shown how, because of synthetic relationships, a debit call spread is essentially the same as a credit put spread and a debit put spread is essentially the same as a credit call spread. The only real difference is the cash transaction–debit or credit–at the time when the spread is initiated. The potential risk and reward, however, is the same once interest and dividend issues are taken into account. This concept can have an important impact on the psychology of managing an ongoing vertical spread trade.
The Psychology of Trading Verticals
Imagine that a trader buys an out-of-the-money debit call spread, say a 50-55 bull call spread with the underlying stock at $49. This trader gains positive delta, positive gamma, negative theta and positive vega. Specifically, in this example:
Out-Of-The-Money Call Debit Spread
Delta = + 0.35
Gamma = + 0.09
Theta = – 0.01
Vega = + 0.04
The positive delta results from the call with the closer-to-the-money strike being purchased. Positive gamma, negative theta and positive vega result from the underlying stock being closer to the long (50) strike than the short (55) strike.
The trader wants the stock to move higher, to or through the short strike, and fast. Why? To avoid the impact of negative theta.
Now imagine that within a short amount of time, the underlying stock does, in fact, move up to, say, $56 a share. What are the trader’s new greeks?
In-The-Money Call Debit Spread
Delta = + 0.35
Gamma = – 0.09
Theta = + 0.01
Vega = – 0.05
Note the delta is still positive; however, the signs of all the other greeks are reversed. That is to say that now there is negative gamma, positive theta and negative vega.
Positive delta still results from the 50s having a higher delta than the 55s. But now the short strike is the dominant influence. With the stock closer to the 55 strike, negative gamma, positive theta and negative vega prevail. At this point, the trader will have made some of the maximum profit that resulted from the long delta, but will still have to wait it out to reap the remainder in the form theta. These greeks would incidentally be about the same as they would be for a 50-55 credit put spread.
The Blurred Line Between Debit Spreads and Credit Spreads
The new goal (presuming the trader doesn’t close the position to take a partial profit) is to wait it out and hope the stock remains above $55 a share until expiration. The trader would, in fact, need to manage this trade as if it were a 50-55 bull (credit) put spread.
This can be a big psychological leap for some traders. It’s not a credit spread; it’s a debit spread. But imagine for a moment, that the trader did not have the debit spread in inventory. If the trader believed the stock (again, now at $56) would stay flat or continue higher, he might consider selling a 50-55 credit put spread. The trader would monitor the trade and wait out time decay and perhaps hope for some gain from the positive delta if the stock continues higher. This is effectively the same position the trader holds with the ITM debit call spread.
Further, think back to the box. It has been shown in Part I of this two-part series that the two spreads are synthetically the same. It becomes a matter of recognizing the flip-flop that can occur from debit call spread to synthetic credit put spread that can help a trader manage the trade accordingly and see more clearly how to view the trade after the stock moves higher.
