Spread Price vs Leg Price

[kchicago 0]

Hi all,

Still trying to get my noggin wrapped around all this.

 

I'm struggling with understanding the purchase of a straddle/strangle, etc. and how to interpret why you're entering where you are entering.  Over time I hope to fully grasp the concepts of IV and the greeks and better understand how you're arriving at the entry price.

 

However, I'm just struggling with the basics of where the Put and Calls are being purchased at the time and what impact it has on the overall odds of a successful play.

 

For instance - on the GMCR straddle you purchased the initial spread for $7.70.  I was able to get filled about 90 minutes later at $7.68.  However, the pricing of each leg of my trade was dramatically different from Kim's.

 

Kim: Put $3.65

        Call $4.05

 

Mine:Put $3.04

        Call $4.64

 

So my fundamental question is... if I'm trying to purchase the spread for a limit of X and I want to sell for a limit of Y do I care where the legs are priced?  Something tells me that I should.  There was a 15-20% swing in the price of the Put/Call between the time of Kim's trade and mine.

 

However, I don't see an option (no pun intended) in my order entry to put in a limit on each leg, only the combo.

 

Thanks - Kent

Edited February 6, 2013 by kchicago

[Marco 221]

the leg prices don't really matter. Your looking to buy the straddle near the price that Kim got and sell it higher than what you bought it for - you don't really care whether your gains come from the call or the put.

 

Usually when we buy an at the money straddle the legs have approximately the same price. Once the stock moves away from the strike one leg will gain more than the other loses (assuming implied vol stays the same) and you make a profit. In the GMCR case the move was big enough to move the legs slightly but not big enough to push up the price of the combo (maybe also IV dropped a bit, so you got it cheaper than Kim). Now we're looking for either an increase in IV (then both legs will go up in price) and/or a big move in the stock (in that case one leg will drop and one will go up) but as I said we only really watch the combo price as thats what we trade and that's where our profit or loss will come from.

[kchicago 0]

Marco,

A little slow in getting back to this forum topic.  Thanks for your detailed reply!  Makes sense.  It's just a new concept for me to watch the flucuations of these spreads hourly.  Just thought I might be missing something.

 

Thanks again,

Kent

[Goonah 0]

Marco or others,

Quick follow up question on this post.  Don't the leg prices above matter to some extent because Kim's trade is more likely to be delta neutral than "mine"?  i.e. assuming the second trade is more delta positive, the value would be more negatively impacted by a decrease in the share price vs Kim's trade. Or are the differences too small to have a material impact?  Would you be better off creating a delta neutral trade by buying more puts than calls in this instance?

[Marco 221]

you're right. If call and put price are about the same thats usually a good sign that the straddle is delta neutral (well with low rates like we have now and no divs in between now and expiry that is). However the difference in above example probably isn't big enough to have created a meaningful long or short delta. Better than looking at the leg prices is to compare the strike price (straddle) or the mid of the strike prices (strangle) vs. stock price. Ideally you want the stock price to be as close to the middle as possible as the price of the combo should be the cheapest then (all else equal) and then it should also be delta neutral. However often 'close enough' will do if the price is good and sometimes the price will go up when the stock edges closer to the strike as IV rises - so I wouldn't obsess too much for the stock to be EXACTLY on the strike.

[Goonah 0]

ok, got it.  thx for clarifying.

[indiana*josh 59]

Quick follow up question on this post.  Don't the leg prices above matter to some extent because Kim's trade is more likely to be delta neutral than "mine"?  i.e. assuming the second trade is more delta positive, the value would be more negatively impacted by a decrease in the share price vs Kim's trade.

 

If you and Kim both own the same options (i.e. same puts and calls with same strikes and expirations) and you both paid the same total price for the combination (regardless of leg prices), then you hold the same position.  Any future developments will have an identical effect on both, right?

[Goonah 0]

Yes i guess that's right but if you entered the second trade you'd be making more of a directional bet at that time whereas I don't think Kim did when he initially made the trade.

[indiana*josh 59]

Yes, that's true.  However, to the extent you are making a directional bet, so are those already in the position who continue to hold it.

[Kim 7,512]

Like Marco mentioned, if the stock is still close to the strike, I wouldn't be too concerned if the individual legs prices are different from my fills. However, if the stock price has mive to the next strike, I would consider going for the straddle on the strike which is the closest to the current price, even if it means a different position. Once you get the idea of those trades, you should be able to manage them, even if your position is slightly different from mine.