A Vertical Debit Spread on SPY

This past Monday in group coaching class, we looked at the S&P 500 ETF (SPY) for a potential vertical debit spread. At the time, the ETF was attempting to surge over some potential resistance from the 200-day moving average. When it did make the surge over the resistance level, it was a bullish opportunity as seen below.

SPY debit spread

But then the question became which strikes and expiration to consider. Since in this case we expected a move sooner than later, it made sense to consider a shorter expiration for two reasons: bigger delta and a possible move to positive theta.

Bigger Delta and Positive Theta

Since deltas gravitate to 0.50 the further out to expiration you go, a shorter expiration for a bull call spread would yield a bigger positive delta than an expiration further out. In addition, a shorter expiration will make theta a factor either in a positive or negative way. Theta becomes more important for both debit and credit verticals with less time to expiration. Let’s look at what we did in class.

Feb-04 445/450

With a potential resistance level from previous pivots at $450, it made sense to consider the 450 strike for the short call on the bull call spread. At the time the ETF was trading at $444.50 so the 445 strike was chosen for the long call. The cost of the spread was 2.50 (5.54 – 3.04). That is the max risk with the max profit being 2.50 as well (difference in the strikes (5) – the cost (2.50)). The delta on the trade was +0.16 (0.50 – 0.34) and the theta was -0.08 (0.54 – 0.62) as seen below.

Spy debit spread 2

Picking a shorter expiration (in this case less than a week) netted a larger positive delta and at the time a larger negative theta than a longer expiration. Lo and behold the forecast was right and the ETF surged $7 higher from the previous day. The positive delta increased with the shorter time to expiration and theta, which was negative, had become positive with the ETF now trading above the 450 short call strike as seen below.

SPY debit spread 3

Although theta had been negative and a cause of concern, it was now positive: 0.13 (0.59 – 0.46). Time passing had helped the position. Between the combination pf positive delta and theta, the spread was up 1.10 ($110 in real terms) ((8.55 – 4.95) – 2.50 (original cost)).

Moral of the Story

The bottom line is if you as an option trader are looking at a potential vertical debit spread and expect a move sooner than later, consider a shorter expiration. The two potential benefits are a bigger delta and a move to positive theta with the correct outlook.

John Kmiecik
Senior Options Instructor
Market Taker Mentoring, Inc.

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