dustinoparker
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Question/thoughts for long spread/iron butterfly traders. My problem is trying to accurately calculate the potential gain in my strategies, factoring in implied volatility.
The problem: Every website on earth tells you the maximum profit from a debit spread is the difference in strikes minus the premium paid. This is correct; it is the "maximum/theoretical profit"
Real life: This never, ever happens. The real life gain is the difference in strike prices minus the difference in time value minus the paid premium.
Example: XYZ = $100
Predicted move of +$5, so we open a 5-point call spread. Let's say we paid $400
BUY $100 CALL - 8.0 paid
Sell $105 CALL - 4.0 received
Stock now moves to $105 - implied volatility dropped due to post-earnings announcement
$100 CALL = +5.50 ($5 in-the-money for intrinsic value, small time value of 0.5)
$105 CALL = -2.0 ($0 in-the-money, 2.0 time value )
_________________________
=3.50
Notice the move happened and we lost $50?
As you can see, an at-the-money strike has a very high amount of time value, which is affecting how much we can sell the spread for. Thus, you can see you will have to subtract the difference in time values from the actual spread to calculate profit. You don't just want your spread; you want even your short call to be WAAYYYY in the money, to shorten the difference in time values.
Does anybody look at these when running calculations? I've had trades recently where I predicted an 8% movement. So, I pick a safe trade....a 4% movement spread. The stock moves 9%, WAYYY above my spread......and I lost money. The volatility was so high in my short contracts, that over 2X my predicted move happened, and it still wasn't profitable.
Perhaps there's a calculations to figure out how far in-the-money the short call has to be in order for the trade to still be profitable?
The problem: Every website on earth tells you the maximum profit from a debit spread is the difference in strikes minus the premium paid. This is correct; it is the "maximum/theoretical profit"
Real life: This never, ever happens. The real life gain is the difference in strike prices minus the difference in time value minus the paid premium.
Example: XYZ = $100
Predicted move of +$5, so we open a 5-point call spread. Let's say we paid $400
BUY $100 CALL - 8.0 paid
Sell $105 CALL - 4.0 received
Stock now moves to $105 - implied volatility dropped due to post-earnings announcement
$100 CALL = +5.50 ($5 in-the-money for intrinsic value, small time value of 0.5)
$105 CALL = -2.0 ($0 in-the-money, 2.0 time value )
_________________________
=3.50
Notice the move happened and we lost $50?
As you can see, an at-the-money strike has a very high amount of time value, which is affecting how much we can sell the spread for. Thus, you can see you will have to subtract the difference in time values from the actual spread to calculate profit. You don't just want your spread; you want even your short call to be WAAYYYY in the money, to shorten the difference in time values.
Does anybody look at these when running calculations? I've had trades recently where I predicted an 8% movement. So, I pick a safe trade....a 4% movement spread. The stock moves 9%, WAYYY above my spread......and I lost money. The volatility was so high in my short contracts, that over 2X my predicted move happened, and it still wasn't profitable.
Perhaps there's a calculations to figure out how far in-the-money the short call has to be in order for the trade to still be profitable?
