S&P 500 and the Call Spread

I placed a spread trade with Optioneer this morning, I don't know if it will get filled unless the market kicks up at least to the morning open levels again, we'll see if it can gain back those 5 points.

Meanwhile I have decided to fund my margin account in order to give my own spreads and strangles a try. I could cheat and try to emulate the Optioneer but I doubt that would work given the different vehicle I will use for this.

First up is to look at SPY as a substitute for the S&P500 index. Right now the index is at 1105 or slightly less and SPY is at $110.70 or slightly less. I could choose other funds that track various markets if I wanted to, even give a run at the Canadian markets I suppose.

So. A call spread is the first thing to look at given the market situation as it stands, which is why I placed a spread call trade already.

SPY being at $110.70 I want to look at the call option chain to see where the best price differences in call strike lies based on my loss allowance. In order to calculate this I will choose $200 for a loss allowance for now, it may change.

A call at $116 strike is worth $0.59 to sell and the $118 strike is worth $0.30 to buy as
protection. This creates $59 in cash and $30 in cost for a single position, less the $20 commissions. The maximum loss is equal to the difference in strike prices 118-116=$2 (times 100 as the contract is for 100 shares) or $200 for the trade less the difference between the sold and protection calls, $59-$30=$29.

Total MLA is $200-$29=$171.

All I have to do is call up Questrade and tell the order desk to sell 1 December 116 Call contract for SPY and buy 1 December 118 Call for SPY. I am not certain about the limit order part as I haven't done this yet but I expect I can instruct the best price to accept...for example :

Sell 1 December 116 Call contract for SPY at 55 cents or better
Buy 1 December 118 Call contract for SPY at 35 cents or better

With this trade I would have to be willing to only make $20 if the prices only get met and not exceeded. Because these have to be placed together as one order they will not fill only one side but giving some allowance or lenience in the limit price gives them a better chance of filling the complete order. I am sure that it could be placed as a market and it would fill at whatever price but I am not sure how their timing will work out. I have, in the past, used the order desk and they have placed and executed trades immediately but they have been buying or selling a stock at market. Perhaps they will give me a quote on the spot and I can go with those numbers and decide to fill or not. I'll try this out once I am properly funded.

Obviously I need to look a little closer at the spread trade in order to get better prices for the spread or just figure on actively managing the trade once it is in place.

The MLA method is great BUT it assumes that my only plan is to let the trade expire in every single case, which is easiest and cheapest. If the chance of a loss grows I can always just close the trade for a small loss or a small profit based on the numbers at that time which would allow me to run a larger position or a larger spread.

The above example yields $29 less the $20 commission (two trades at $10) or $9. Hardly worth the effort. Using four contracts the return increases as the commissions only go up $1 per contract. Total commissions ($10+$3)x2 = $26. Total return $29x4 = $116. Net return = $90.

The MLA of this trade would be the spread value of $2 x 400 shares = $400 less the return of the trade $90 = $310.

The return vs risk seems skewed but the odds are in favour of the option seller so a higher risk is worth the effort...maybe in this particular example the risk is a little too high but that is where option selection is important. Trying to sell high value options and buy lower value increases the return but can increase the risk if widening the spread is how this is accomplished.

I think that if an index ETF is going to be used then just watching for the best price discrepancies is the best bet and buying when the quote spread is smaller.

Jeff.