Target return in option strategies (Excel) transcript

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So, please check the link in the description or click the join button below for more details. My name is Seppa, and today we're investigating a key concept in option trading. That is, how to target your payoffs and returns for a speculative option trading strategy, and how to choose one out of many feasible alternatives for options trading. And we'll investigate it based on one of the simpler option spreads or option portfolios that are the bullish call spreads, which involve longing an at-the-money call option and shorting an out-of-the-money call option to provide some cash for the initial downside, as well as capping your payoff at the upper end of your share price forecast.

And the example for today would be IBM, and we'll trade options for a 6-week period from 28th of February 2022 until the 14th of April expiry. And the center price, the price of the underlying as of the start date, is $124.18. And here are the uh bid and ask prices for call options at various strikes that available to us at this particular date. And we will investigate how to do uh return targeting, and we'll also investigate how margining for short options affects target return calculations and our initial investment.

So, first of all, we have to come up with a target price. That is the price we believe the IBM stock is going to be traded at as of 14th of April. And the target price is a key component of directional strategies, which bullish call spreads um undoubtedly are. And let's say that we uh believe that IBM is going to be traded at $128 per share. So, a reasonably bullish outlook. Meaning that bullish call spreads are uh theoretically feasible for such a strategy to be profitable.

And here we have to investigate our at-the-money long call, and at-the-money strike would be 125. That is the uh closest available strike to the center price. So, it would be 125 strike. And as it's a long call, we'll need to buy it at the ask for our trading strategy simulation to be robust. So, the premium is going to be $4 per share. And we'll consider four possible uh out-of-the-money calls to construct our bullish call spread at 130, 135, 140, and finally 145.

And as these would be the short options to finalize our spreads, we will sell them at bids. So, at 1.75, 0.7, 0.25, and 0.12 dollars per share respectively. And we have to simulate a range of uh underlying prices, and here we can apply it using the sequence function. And let's go from $100 per share to $150 per share, simulating a wide enough but believable range. And let's go uh 50 cents at a time. Meaning that we will need 101 rows from 100 to 150, half um a dollar per step plus the initial step, isn't it?

We'll just need one column. We'll start at a hundred and we'll move 0.5 dollars at a time. That constructs the correct range of underlying prices we would like to consider. And now we can construct the payoffs for our long and short call options. So for the long call, we need to pay the premium, so negative premium here and we'll lock the row as the premium doesn't change no matter what the price of the underlying is.

And then we need to add the gross payoff of the call option, meaning the maximum of zero if we do not exercise our call and the difference between the underlying price and the strike price if we do. As the call option is the opportunity to buy at the strike, so we'd exercise it if the price of the underlying is higher than the strike, so we can buy the strike, sell, uh, at the spot market and, uh, capitalize on the difference.

That would be our gross profit. So we'll subtract from the underlying price here and we'll lock the column as this does not, uh, change no matter what option we consider. And then we subtract the strike where we have to lock the row as the strike changes option to option but does not change simulation to simulation. That correctly calculates the payoff of the long call which we can apply throughout our payoff structure.

Now we'll have to consider our four short call options and to implement it fast and efficiently, we can just drag it across here and change this function to represent not a long call payoff structure but rather a short call payoff structure. To do that, we have to simply change this minus into a plus as we're receiving the premium for a short call option, not paying it, and change this plus into a minus. As we are not capitalizing on the gross payoff of the call option if we short it, but rather it is our gross loss if the counterparty of ours executes the call option at our expense.

That allows us to efficiently calculate the net payoff structure for all four short call options that we can consider for our bullish call spread. And finally, we can construct the payoff structures of all five potential strategies. The first strategy is just a naked long call where we do not combine it with any short call at all to finalize the spread, we just go for the simple strategy. So, we just refer to this payoff for the bullish call spread at 130.

We combine this short call payoff structure with the original long call, and to implement it faster, we can lock the column here as the long call is the same for all four potential bullish call spreads. So, here we can drag the cross, and we can enforce these functions all the way down. And here we can see how the chart over here represents payoff structures of five competing strategies. We can see that if we cap our payoff quite soon at a quite low comparatively strike, for example, for a bullish call spread at 130, we cap our payoff very early, so we are not benefiting from further upside if the IBM share price goes beyond 130.

However, as the bid price for the 130 call is comparatively large, we do receive quite a bit of cash to provide for the quite high price of the long call that we purchased. And this is the trade-off that we have to consider. How fast do we want to cap our payoff at? So, comparing our foregone upside here to the benefit that we receive from the proceeds of our short call. And the dynamics here are twofold. First of all, the payoff changes.

The payoff per share does vary depending on what we choose. And second, the return of our strategy can change all the more so as shorting a call option can allow us to gain more exposure as we are not fully investing our capital into the long option, but we gain some cash from shorting the options as well. So, we effectively are leveraging our strategy so returns can be higher. And let's visualize it here. So, first of all, for our target price of 128, we can go here to the bottom and refer to our target price of 128 in this instance.

And then we can copy this full row over here to represent net payoffs per share of each and every of the strategies at 128. So, further, what we need to do is we need to calculate the net premium for each and every of these strategies. For the simple long call, it is just $4 per share. That's our investment amount. And the target return is obviously the net payoff of the strategy per share divided by net investment amount per share, which gives us a target return of -25%.

Meaning that going for a long call at the strike price of 125, if our forecast is 128, is not feasible really. What happens if we can investigate the spreads where we combine a long call with a short call? Well, first of all, we still do invest $4 per share into the long call premium and that can be locked column-wise. And then we subtract the premium that we receive by short selling or writing the call option out of the money.

So, our net investment amount is lower, which can boost our returns if we design our spread correctly. However, most of the time writing options is associated with margin requirements as exchanges worried that a shorting counterparty for the option might strategically or honestly default on their obligations to provide for the exercise of the option by the counterparty they've written it to. So, what happens is that part of the premium that we received needs to be deposited to the margin account with the exchange.

And that means have to add to our net investment amount the short option premium times the margin level or the margin percentage. Here we haven't filled it in yet, so assume it to be zero for now and this can be locked because margin requirements are generally quite universal across exchanges. They are most of the time specified as percentages of what you receive from shorting an asset and in this case shorting an option.

So, we see that for this particular specification our net investment amounts are smaller for our spreads that involve short call options. And if we drag the return calculation all the way through, we'll be able to see that the bullish call spread with a strike of 130 for our short call option provides us with the only positive return at 33.33%. Given the fact that this option breaks even quite a bit faster than um its uh counterparts uh because the premium that we receive for shorting a call is substantially large to balance out the downside of $4 per share associated with longing a call.

However, if we increase the margin, for example, to 50%, the returns would go down simply because here the investment amount would increase as we need to deposit part of the proceeds from the short call within our margin account, effectively increasing our net investment amount. And sometimes the margin requirements, the margin levels for short uh selling can be even higher than 100%, meaning that have you'll have to deposit more than you have received from a short sale.

And uh most of the time uh such levels are equal to 150%, especially in the US. And you can see how that brings the returns of this particular bullish call spread even further down. Now, we can also see how the change in the target price affects the optimality of uh particular strategies. So, if we're a little bit more bullish than 128 target price, so for example, if our target is now 130, we can see that all of our uh bullish strategies become profitable now with positive target returns.

Uh and the bullish call spread with a strike of 130 remains the most profitable, though. If we go even further to 135, we see that now the bullish call spread at 135 strike becomes the most profitable of the five in terms of its uh net uh return. And if we go even further to, for example, 137, we'll see that at 137, we are indifferent between a naked long call and the two further out of the money spreads at 140 and 145.

So, and if it's 138 further, then we see that a simple long call becomes the most beneficial to us in terms of the combination of net payoff per share and the initial investment amount. However, if the margin goes down to 50% for example, uh a spread that gets you some money back if a margin is less stringent is still more profitable. And this illustration provides you with a lot of insight into what shapes the profitability or optimality of competing option strategies and option spreads.

The choice of the strike for the short call to combine with your initial long call option can be shaped both by the pricing of the options. If the premium here are larger, these strategies are more attractive as they provide you with more cash, boosting your returns and allowing you to break even faster. Also, these strikes can correspond to your target price forecast. It's not a coincidence that if margins are relatively low, the target price of 138 um involves the bullish call spread with the short call strike, that is the price at which your upside is capped, being the most attractive.

And what you also need to consider are margin requirements that can be put in place for short options trading. The higher they are, the less favorable option strategies that involve shorting the options are in terms of returns. And that's all there is for return targeting with bullish call spreads, taking into account uh different options that are available to you and different margin requirements that might be put in place by your exchange.

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