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Real Time Options Spread Trading---MSFT

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rmr1976

Posted : Thursday, May 19, 2005 12:02:39 AM

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Joined: 12/19/2004
Posts: 457

Today, I was filled for a spread trade I am putting on for MSFT. I will post here periodically, describing the results of the strategy, for those interested in using options to enhance their trading strategy and tactics. I'll post every Friday with the week end results of the trade, and any adjustments I decide to make.

Spread Trade: Long 6 Jan 27.50 calls at 0.92. Debit: $552.00
Short 3 Jul 25.00 calls at 1.15. Credit: $345.00
Net Debit: $207.00

Risk/Reward Profile: This spread has a bullish bias, as there are more long calls than short calls. The spread has unlimitted profit potential before the July expiration if MSFT is higher than $27.50.

The spread also makes partial profits on a small decline in MSFT. If MSFT slightly below $25.00 at expiration, the spread could be closed for a profit of $169.00, IF implied volatility remains around 20%.

Calculating breakeven levels for this type of spread is difficult without options software. They change depending upon the volatility assumption you use.

For example, using a 20% volatility assumption for the option model, this spread is profitable for any price above 24. If the volatility assumption used is 17%, the spread hovers at a slight loss, until the stock is at $24.00, when the loss becomes greater than $100.00. As long as MSFT stays steady or moves higher, the spread will be close to breakeven. Of course, the spread makes money on a sharp upward move in MSFT.

There are 3 ways to make money on this spread. First, if MSFT moves sharply higher, the spread will make a profit. Second, MSFT option premiums could increase, making the long calls more valuable. This increase in volatility won't have as much impact on the short calls.
Third, we might be fortunate to have MSFT remain relatively stable, giving you the chance to take in more time premium when the short calls near expiration.

If catastrophe hits, and you choose to do nothing, your max risk prior to expiration is the debit: $207.00. That is the MAX loss you could possibly see. This ignores the possibility of adjusting the position to market conditions by converting to bear spreads.

On the plus side, suppose we manage to have MSFT close just below 25 in July at expiration. We will have earned that entire premium from the short options, and still have the long options in our account. We could write 2 or 3 new options to bring in more premium, which may turn this spread into a risk free bullish trade in MSFT, while still giving us unlimitted profit potential on a strong upward move.

Suppose IV has risen enough to make writing the October $27.50 call worthwhile. In July, it is trading at an IV of 20%. That option would bring in 1.19 if sold. If we sold 3, we bring in a cash inflow of $357.00 minus commissions. We are still long the January options, so this is a ratio calendar spread.

Since the initial debit was only $207.00, this second write has created a risk free trade. If MSFT collapses, we will make $150.00 (357 credit from second write, minus 207 initial debit) if all our options expire worthless. This neglects the possibility that we could hold the long options unhedged after October, and have a strong rally in our favor occur.

We still remain profitable if MSFT breaks out over $27.50, and there is no cap on our profits, as there are still 3 long, unhedged options.

Using this spread strategy, we were able to do the following:

1. Keep our initial risk small. In this case, the maximum, catastrophe loss, was about 200 bucks, and got smaller over time after near term expiration.

2. Reduce that risk over time by writing premium. As long as MSFT stays within the current trading range, we can make adjustments to reduce the initial debit.

3. Set up a position with unlimitted profit potential.

Feel free to post any questions regarding this strategy.

Sir Knowledgable Skeptic.

rmr1976

Posted : Friday, May 27, 2005 6:00:38 PM

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Joined: 12/19/2004
Posts: 457

MSFT Spread Update:

I put on a MSFT spread last Thursday. As promised, I am updating the trade every week.

As of the market close, the spread has a loss of $105 at this point.

6 MSFT Jan 27 Call: Long at .0925 Current: .90.
Net loss = 6 * [100 * (.925 - .90)] = $15.00

2 MSFT July 25 Calls: Short at 1.15 Current: 1.45
Net Loss = 3 * [100 * (1.45 - 1.15)] = $90.00

Total Loss: $105.00

There are those who are probably wondering why a bullish trade in MSFT options shows a loss when MSFT rose.

The answer is implied volatility. When we bought the option, the implied volatility was 17.5% The implied volatility of the call now is 17.81. This change in volatility did not do much to increase the option price.

Compare this minimal price change in the long option to to the short call. The call, because it is short and has some intrinsic value, moves much more in accord with the underlying stock. MSFT rose 1/2 point.

That was equal to a 15 cent move in the option (roughly a 13% increase in the short option value).

After 1 week, there hasn't been long enough for time decay to work in our favor. Nor has volatility on MSFT options increased, which would help our position.

My initial post indicated that it was likely this position would show a small loss of aprox $100 prior to expiration if implied volatility did not rise to around 20%. This is the case now, so the spread is temporarily in the red.

What was (and still is) the advantage of the spread over the long option? First, there was (and still is) a chance for MSFT to move down before July. That would benefit the spread significantly. We could own the long calls for significantly reduced cost.

If, MSFT had moved down, our loss would have been larger, although it was limitted to the initial debit for the calls.

There is also the issue of time decay. Long options, as everyone knows, are wasting assets. The spread allows a trader to minimize, and sometimes even take advangate of, time decay. Should MSFT stay near 25-26, the spread will become profitable if volatility does rise. If it doesn't, we will adjust around expiration, hopefully for at least breakeven.

Keep in mind, should MSFT rise rapidly, the spread will show a profit. Volatility is likely to go up, which helps the position. If MSFT falls, the spread will also show a profit, as the short option will lose value, and volatility will increase.

The max risk of the spread is still limitted. MSFT can fall below 20, and the most at risk is the initial debit. It would then be possible to adjust, and convert to a bearish call spread trade, and take in more premium, using the long calls as a hedge.

robwiley

Posted : Saturday, May 28, 2005 8:39:14 PM

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Joined: 3/9/2005
Posts: 71

Good to see you wisely use a hedge type play. Limited calculated risk is nice to know before entry. I know spread trades reasonably well also. Currently am near the end of a test phase of a PCF scan strategy that I wrote and like the results which is dwelling around the 70+% success rate. Using spread trades should be beneficial over time according to existing results. I chose a time erosion basis theory. From here it is a matter of ATM-ITM OR OTM-ATM.

rmr1976

Posted : Friday, June 3, 2005 5:25:50 PM

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Joined: 12/19/2004
Posts: 457

MSFT Spread Update:

The market action today helped the spread somewhat. MSFT closed down $0.36 today to $25.43.

This caused the short July 25 calls to close at $0.90, for a gain of $75. Unfortunately for the spread, volatility on MSFT options continues to work its way lower. The Jan 06 calls closed at $0.74, a loss of $111.00

The total loss on the spread--a whopping -$36.00 which is an improvement from being down -$90.00

There isn't any need to adjust the position. The goal is to have the short calls expire, then we convert to a different spread, preferably for a credit.

Market volatility is very low. It is so low, the puts on the QQQ aren't even worth selling. This low volatility makes me nervous. I wouldn't want to be short any puts in this market. Although I'm bullish, the profit potential in option writing strategies is simply nonexistent.

rmr1976

Posted : Friday, June 10, 2005 5:09:38 PM

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Posts: 457

MSFT Spread Update:

MSFT closed today at 25.43, for a loss of $0.08, or 0.31%.

The long Jan 06 27.50 calls closed at $0.65 today, for a loss of $165.

The short July 25 calls closed at $0.85, for a gain of $90

The net loss on the position increased slightly to $75, vs. $36 last week.

The trade is proceeding according to plan--almost. There is a good chance we will be able to buy back the MSFT options for a fraction of the value we sold them for.

On the negatvie side, IV of our long options has decreased. Considering the cheap value of the Jan 06 calls, it might be a good idea to add to the position, once July expiration rolls around.

We can add to the position by buying more Jan calls, and selling greater amount of shorter term calls, and bring in a credit. All the short calls are covered by the long options we previously bought at the start of the trade.

It will depend upon what implied volatility levels are when the trade is adjusted, but it might be possible to build a large, bullish position in MSFT calls for essentially zero debit, or maybe a credit of $100 or so.

Then, the position will have the potential for large gains if MSFT should rise to the strike price, or higher. Ideally, we would be able to hold a large position in MSFT calls for a small credit, have the second set of short options expire, leaving us with a net long position, unhedged.

rmr1976

Posted : Friday, June 17, 2005 7:11:46 PM

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Joined: 12/19/2004
Posts: 457

MSFT Spread update:

MSFT closed at 25.04. The July 25 Call last traded at 0.45. The January 27.50 call is also trading at .045.

The spread is hovering at a $75 loss at this point. However, MSFT has a very strong chance of moving below the short strike. As this option has less than a month remaining, that time premium will erode very quickly. It will be useful to watch the action in MSFT very closely, for an opportune time to cover the short option.

rmr1976

Posted : Friday, June 24, 2005 9:04:30 PM

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Posts: 457

MSFT Spread Update:

Just as last week, MSFT closed at 25.04. The long Jan 27 call continues to trade at 0.45. The short July 25 call is trading at 0.40. Currently, the spread is showing a $60 loss.

As the short call is mostly time premium, I'm probably going to wait until after the holiday before I make any adjustments. By then, time decay will really be working in favor of the spread. It also gives MSFT a chance to move below 25.

The next move, after the short calls are either covered or expire, is to place a Jan 25/Oct 25 ratio calendar underneath the long 27 calls. This will increase the position size, while also taking in more premium to offset the initial purchase of the 27 calls.

mastertrader1

Posted : Tuesday, June 28, 2005 8:19:35 PM

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Joined: 4/5/2005
Posts: 1

I was curious on how this trade turned out for you, would you please post an update on how this trade ended.

thanks
mastertrader1

rmr1976

Posted : Tuesday, June 28, 2005 11:47:46 PM

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Joined: 12/19/2004
Posts: 457

Mastertrader,

I'm still involved in the trade--it hasn't ended yet. I don't plan on doing anything until after the holiday. After the weekend, option traders will adjust the models, and a significant chunk of premium will be gone.

I might cover, I might not. I'm still not sure yet. I'm inclined to leave well enough alone, and let more time decay take its toll.

I plan on holding the MSFT calls until at least November. I also plan on adding to the position by putting on a calendar spread. As I promised, I'll keep posting updates on how the spread turns out.

rmr1976

Posted : Monday, July 11, 2005 5:36:18 PM

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Joined: 12/19/2004
Posts: 457

MSFT Spread Update:

This week is options expiration week. In light of the current market action, I covered the short July 25 calls for 0.40 per contract. Including commissions, the debit was $134.95.

The initial credit we took in was $345.00. This leg of the spread was closed out for a profit of 210.05.

In retrospect, I should have covered the short options last week, when I could have bought back the calls for $15 per contract. The delay cost me about $70.

There is still an unrealized loss on the long calls. When everything is netted out, the spread is still slightly below breakeven. Later in the week, I plan on adjusting the position, although I'm not sure exactly what I will do. I intend to observe the market action for a few days before putting on another MSFT trade.

rmr1976

Posted : Wednesday, August 3, 2005 10:09:27 PM

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Posts: 457

MSFT spread update:

It has been a few weeks since I've posted about how this MSFT spread is turning out.

After the market rallied from the London attacks, after I closed out the short July calls, I did not make any adjustments until last week.

MSFT had released earnings that did not impress the market, and MSFT sold off sharply. Based on that response, I thought the lateral trend on the weekly would continue longer. I decided to add to my position, while hedging against any near term weakness.

I put on a 5 long 9 short ratio calendar spread underneath my 6 long MSFT 27.50.

BTO 5 Jan 06 25 calls: 1.70 = -850
STO 9 Sep 05 25 calls 0.90 = +810
Debit: -40

I had expected MSFT to trade sideways or down over the near term, and had expected to make a profit on the short calls.

After yesterday's breakout for MSFT, I decided it would be wise to cover the short calls, and placed a very tight limit order that was filled at market open.

BTO 9 Sep 05 25 calls: 1.95 = -1755

I was hedged on 5 of the calls, so the loss on the short calls was not as bad as it looks.

Gains:
Short Jul 05 25 3(1.15 - 0.4) = + 225
Long Jan 06 25 5(2.55 - 1.70) = + 425
Long Jan 06 27.5 6(1.15 - 0.925) = + 135
Gross: = + 785

Loss:
Short Sep 05 25 9(1.95 - 0.90) = - 945

Net Loss: $160.00

The total position in MSFT is increased to 11 contracts:
5 Jan 06 25 calls
6 Jan 06 27.50 calls
Position delta: 566

The position will show significant profits on a rise in MSFT. I do plan on hedging some of the risk later this week by converting to another type of spread.

bknight

Posted : Wednesday, August 3, 2005 10:23:52 PM

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Joined: 12/19/2004
Posts: 415

I think it may pause at this point, since it is near the Nov 04 high, trade down/sideways then push to new highs.

rmr1976

Posted : Friday, August 5, 2005 10:07:21 PM

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Joined: 12/19/2004
Posts: 457

MSFT Spread Update:

As mentioned in my earlier post this week, I adjusted my MSFT position so that I was long 11 calls. Today, I managed to see the market close, and decided to hedge some of my msft gains by selling 5 Sept 27.50 calls for 0.75.

That provides a decent amount of downside protection. The breakeven for the position is somewhere around 25.

rmr1976

Posted : Tuesday, August 9, 2005 12:16:29 AM

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Joined: 12/19/2004
Posts: 457

MSFT Update.

Well, it appears hedging last Friday was a good move. I'm planning on adding additional short calls to my MSFT position, converting to a combined calendar/diagonal bull spread.

The entire position looks like this:
Long: 5 Jan 25 + 6 Jan 27.50.
Short 5 Sept 27.50 + 5 Oct 27.50.

I'll have taken about $700 in premium, once this second trade is placed tomorrow.

The trade is at breakeven (no gain or loss) if MSFT falls to $25.

cwang

Posted : Tuesday, August 9, 2005 9:44:20 PM

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Joined: 7/18/2005
Posts: 3

HI RMR:

Thanks for sharing your knowledge, but I have to say this strategy is not one strategy.

What you are really doing here is making two positions, and they have nothing to do with each other.

Your first position is the 2 calendar positions (2 or 1 don't really make a big difference). with the calendar positions, you are trading the volatility, and being direction neutral.

Your second position is this one extra long call position. You are trading with bullish direction. Technically speaking, the second position is volatility bearish position, and combined with a volatility bullish calendar spread, you can make a valatility neutral position to just long without the fear of losing value while holding them. However, you are putting a lot of strength in the calendars to make sure you also make money on volatility.

At the end, these two positions are not hedging each other, therefore, they are really two seperate strategies trading on their own, one is trading vol, another one is trading direction.

rmr1976

Posted : Tuesday, August 9, 2005 11:46:56 PM

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Joined: 12/19/2004
Posts: 457

CWang,

I'm not quite sure what you are getting at, but I do know it is wrong to say the spreads have "nothng" to do with each other.

When you trade options, you trade certain risks for other risks that you avoid by simply owning stock.

Option buyers have limitted risk on their trades. But, they now have to deal with time decay, volatility, etc.
Those are all things that need to be looked at when putting on a spread position.

The initial trade was a calendar backspread. My long term opinion on MSFT is bullish. Near term was neutral. The short calls partially offset the risk of owning the long calls if MSFT drops, while still having profit potential if MSFT rises before expiration.

The whole point was to be able to hold the long calls, even if MSFT drops. So it is fair to say the short calls do partially hedge against a drop in price.

The spread also hedges time decay risk of owning only long calls. If MSFT does nothing, those calls will decline in value, and I'll be able to buy them back at a profit.

Of course, it helps that MSFT volatility is very low, so that is another factor that justifies the trade. If volatility increases, my long calls will increase faster than the short calls, giving me another way of making money over someone who only holds the stock.

The entire point of these spreads is to (hopefully) sell enough premium over time to reduce the cost of the long options to zero, as you build a large position. Once that is done, you have a risk free trade, and can hold the long options to expiration, if that is desirable.

Since MSFT broke out, it is looking a bit overbought. I decided to minimize some of the risk of MSFT pulling back by selling some shorter term calls. This is very similar to selling calls on a stock you already own. I'm just using options instead of stock.

Looking at the trade in total, the graph now is very similar to a covered call, as I have some ITM and ATM options. My breakeven is 25, and the position is profitable for all prices over that.

You can't just break up the position into pieces and say they have nothing to do with each other. Yes, I have calendar spreads, and diagonal call spreads. But the combined risk of each spread needs to be looked at to see if the trade makes sense.

rmr1976

Posted : Thursday, September 22, 2005 4:19:06 PM

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Posts: 457

MSFT Spread Update:

Last time I posted, I had shorted MSFT calls when it was at an interim high, near 27.50, to hedge some of my long calls.

The Sept options expired worthless, so I got to keep the initial $375 from the Sept. options.

Today, I covered my short October 27.50 calls for 0.1. I had originally sold them for 0.70, for a profit of $300 before commissions.

In addition, I rolled down to the Oct 25 strike and sold 8 for .7688. When the roll was complete, I netted a credit of $550.

The new position provides slightly more downside protection in the event of a market decline. The breakeven is pushed below 24 in case MSFT drops sharply before October expiration.

rmr1976

Posted : Thursday, September 22, 2005 4:47:20 PM

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Posts: 457

Actually, I reviewed my records, and the prior analysis is not correct.

The current MSFT spread has mark to market loss of $726.00, due to the loss the short Sept options (See Aug 3 2005 post).

At the time, MSFT had advanced, so the loss on the short calls was offset by the gains on the long calls.

Since Sept. expiration, MSFT had declined, but I had not instituted any hedge to protect against further losses.
This failure to hedge after expiration increased the loss on the position. I should have immediately rolled down to the 25 strike after expiration.

Now, if I am able to make a profit on these spreads by October, the position will be close to breakeven again, and the risk will be reduced.

rmr1976

Posted : Wednesday, September 28, 2005 6:06:36 PM

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Joined: 12/19/2004
Posts: 457

MSFT Spread update:

On Monday, the market appeared to be heading higher in early AM trading. As I'm basically bullish on MSFT, I had decided to cover those short calls at roughly breakeven. Now, I'm just long 11 MSFT calls.

There was an interesting article on The Street today. Bullish options activity was noted in LU and MSFT. A good friend of mine, with experience in technology, tells me MSFT has a huge number of products in the pipeline, any of them could be a potential blockbuster. He also tells me that the Xbox gaming numbers look very strong.

Technically, my opinion didn't differ significantly from Mr. Worden. MSFT looked like a buy, and I had hedged just in case the market dragged it lower. But the stock had held up pretty well, so I covered the short calls and don't intend on making any adjustments until MSFT is higher.

rmr1976

Posted : Wednesday, November 2, 2005 3:44:24 PM

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Joined: 12/19/2004
Posts: 457

It looks like MSFT has put in a near term bottom.

During the entire correction, I held the MSFT calls unhedged. I was a bit worried when MSFT had dropped below 25, but there was such support, I decided to hold.

It is up strongly today. I plan on keeping it simple from here on out. The trailing stop on MSFT is the 21 day exponential moving average. I will continue to move up the stop, depending on how I view the indicators and chart patterns.

As I'm a longer term bear on the market, I'm looking to exit my position on MSFT on some type of strength. This is what my plan looks like.

Target: $30.00--will re-evaluate

Initial Stop: CLOSE below 21 day exp. moving average.

Raise stop to 13 day exp. moving average when 2 divergences are seen on the weekly. Also place Above market sell order (One cancels Other) above 2 SD above 21 day simple moving average.

Raise stop further to 5 day exp. moving average when 1 divergence is seen on daily. Also place above market sell order (One cancels Other) between 1 and 2 BB above 21 day simple moving average.

rmr1976

Posted : Saturday, November 26, 2005 8:29:14 PM

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Joined: 12/19/2004
Posts: 457

Trade update:

On Friday, I sold my MSFT 25 calls at market open for 3.00 per contract.

MSFT has made a sharp move up, and everyone I talk to is absolutely bullish on MSFT. They may be right, but I had moved my stop up very close to the 5 day moving average. Wednesday was a borderline day---it closed 1 cent above the 5 day exp. moving average.

I decided it was a good idea to take some partial profits. I'm going to hold the remaining calls as long as MSFT continues to do well, and will consider selling them if MSFT closes below 27.31 (13 day exp. moving average).

GameOver22

Posted : Saturday, November 26, 2005 9:41:23 PM

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Joined: 10/12/2005
Posts: 90

How much have you made in total, as im lost here?

LOL

Matt

rmr1976

Posted : Sunday, November 27, 2005 11:08:09 AM

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Joined: 12/19/2004
Posts: 457

Despite the big loser of 945 on the short calls, I'm still up a little over $400, with the chance to make more, as I'm still long 5 Jan 27.50 calls. If I hadn't made that unprofitable adjustment, I'd be up about $1500.

rmr1976

Posted : Tuesday, November 29, 2005 5:36:18 PM

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Joined: 12/19/2004
Posts: 457

MSFT Update:

I'm selling the remaining MSFT calls at market open for a small loss. MSFT is showing signs of weakness after that monster rally from the October low. I expect a market sell off any day now, and I don't want to take the chance of MSFT pulling back sharply.

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