Wingspreads Explained

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Wingspreads

Wingspreads refers to a family of spreads whose profit graphs have shapes resembling creatures that take to the sky. They are trading strategies with neutral outlook on the underlying security and have exotic names like butterflies and condors.

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Yield Spread

What Is a Yield Spread?

A yield spread is the difference between yields on differing debt instruments of varying maturities, credit ratings, issuer, or risk level, calculated by deducting the yield of one instrument from the other. This difference is most often expressed in basis points (bps) or percentage points.

Yield spreads are commonly quoted in terms of one yield versus that of U.S. Treasuries, where it is called the credit spread. For example, if the five-year Treasury bond is at 5% and the 30-year Treasury bond is at 6%, the yield spread between the two debt instruments is 1%. If the 30-year bond is trading at 6%, then based on the historical yield spread, the five-year bond should be trading at around 1%, making it very attractive at its current yield of 5%.

Key Takeaways

  • A yield spread is a difference between the quoted rate of return on different debt instruments which often have varying maturities, credit ratings, and risk.
  • The spread is straightforward to calculate since you subtract the yield of one from that of the other in terms of percentage or basis points.
  • Yield spreads are often quoted in terms of a yield versus U.S. Treasuries, or a yield versus AAA-rated corporate bonds.
  • When yield spreads expand or contract, it can signal changes in the underlying economy or financial markets.

Yield Spread

Understanding Yield Spread

The yield spread is a key metric that bond investors use when gauging the level of expense for a bond or group of bonds. For example, if one bond is yielding 7% and another is yielding 4%, the spread is 3 percentage points or 300 basis points. Non-Treasury bonds are generally evaluated based on the difference between their yield and the yield on a Treasury bond of comparable maturity.

A bond credit spread reflects the difference in yield between a treasury and corporate bond of the same maturity. Debt issued by the United States Treasury is used as the benchmark in the financial industry due to its risk-free status being backed by the full faith and credit of the U.S. government. US Treasury (government-issued) bonds are considered to be the closest thing to a risk-free investment, as the probability of default is almost non-existent. Investors have the utmost confidence in getting repaid.

Yield Spread and Risk

Typically, the higher the risk a bond or asset class carries, the higher its yield spread. When an investment is viewed as low-risk, investors do not require a large yield for tying up their cash. However, if an investment is viewed as a higher risk, investors demand adequate compensation through a higher yield spread in exchange for taking on the risk of their principal declining.

For example, a bond issued by a large, financially healthy company typically trades at a relatively low spread in relation to U.S. Treasuries. In contrast, a bond issued by a smaller company with weaker financial strength typically trades at a higher spread relative to Treasuries. For this reason, bonds in emerging markets and developed markets, as well as similar securities with different maturities, typically trade at significantly different yields.

Yield Spread Movements

Because bond yields are often changing, yield spreads are as well. The direction of the spread may increase or widen, meaning the yield difference between the two bonds is increasing, and one sector is performing better than another. When spreads narrow, the yield difference is decreasing, and one sector is performing more poorly than another. For example, the yield on a high-yield bond index moves from 7% to 7.5%. At the same time, the yield on the 10-year Treasury remains at 2%. The spread moved from 500 basis points to 550 basis points, indicating that high-yield bonds underperformed Treasuries during that time period.

When compared to the historical trend, yield spreads between Treasuries of different maturities may indicate how investors are viewing economic conditions. Widening spreads typically lead to a positive yield curve, indicating stable economic conditions in the future. Conversely, when falling spreads contract, worsening economic conditions may be coming, resulting in a flattening of the yield curve.

Other Yield Spreads

A zero-volatility spread (Z-spread) measures the spread realized by the investor over the entire Treasury spot-rate curve, assuming the bond would be held until maturity. This method can be a time-consuming process, as it requires a lot of calculations based on trial and error. You would basically start by trying one spread figure and run the calculations to see if the present value of the cash flows equals the bond’s price. If not, you have to start over and keep trying until the two values are equal.

The high-yield bond spread is the percentage difference in current yields of various classes of high-yield bonds compared against investment-grade (e.g. AAA-rated) corporate bonds, Treasury bonds, or another benchmark bond measure. High-yield bond spreads that are wider than the historical average suggests greater credit and default risk for junk bonds.

An option-adjusted spread (OAS) converts the difference between the fair price and market price, expressed as a dollar value, and converts that value into a yield measure. Interest rate volatility plays an essential part in the OAS formula. The option embedded in the security can impact the cash flows, which is something that must be considered when calculating the value of the security.

Iron Condors

The iron condor is a limited risk, non-directional option trading strategy that is designed to have a large probability of earning a small limited profit when the underlying security is perceived to have low volatility. The iron condor strategy can also be visualized as a combination of a bull put spread and a bear call spread.

Iron Condor Construction
Sell 1 OTM Put
Buy 1 OTM Put (Lower Strike)
Sell 1 OTM Call
Buy 1 OTM Call (Higher Strike)

Using options expiring on the same expiration month, the option trader creates an iron condor by selling a lower strike out-of-the-money put, buying an even lower strike out-of-the-money put, selling a higher strike out-of-the-money call and buying another even higher strike out-of-the-money call. This results in a net credit to put on the trade.

Limited Profit

Maximum gain for the iron condor strategy is equal to the net credit received when entering the trade. Maximum profit is attained when the underlying stock price at expiration is between the strikes of the call and put sold. At this price, all the options expire worthless.

The formula for calculating maximum profit is given below:

  • Max Profit = Net Premium Received – Commissions Paid
  • Max Profit Achieved When Price of Underlying is in between Strike Prices of the Short Put and the Short Call

Limited Risk

Maximum loss for the iron condor spread is also limited but significantly higher than the maximum profit. It occurs when the stock price falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In either situation, maximum loss is equal to the difference in strike between the calls (or puts) minus the net credit received when entering the trade.

The formula for calculating maximum loss is given below:

  • Max Loss = Strike Price of Long Call – Strike Price of Short Call – Net Premium Received + Commissions Paid
  • Max Loss Occurs When Price of Underlying >= Strike Price of Long Call OR Price of Underlying

Breakeven Point(s)

There are 2 break-even points for the iron condor position. The breakeven points can be calculated using the following formulae.

  • Upper Breakeven Point = Strike Price of Short Call + Net Premium Received
  • Lower Breakeven Point = Strike Price of Short Put – Net Premium Received

Example

Suppose XYZ stock is trading at $45 in June. An options trader executes an iron condor by buying a JUL 35 put for $50, writing a JUL 40 put for $100, writing another JUL 50 call for $100 and buying another JUL 55 call for $50. The net credit received when entering the trade is $100, which is also his maximum possible profit.

On expiration in July, XYZ stock is still trading at $45. All the 4 options expire worthless and the options trader gets to keep the entire credit received as profit. This is also his maximum possible profit.

If XYZ stock is instead trading at $35 on expiration, all the options except the JUL 40 put sold expire worthless. The JUL 40 put has an intrinsic value of $500. This option has to be bought back to exit the trade. Thus, subtracting his initial $100 credit received, the options trader suffers his maximum possible loss of $400. This maximum loss situation also occurs if the stock price had gone up to $55 instead.

To further see why $400 is the maximum possible loss, lets examine what happens when the stock price falls to $30 on expiration. At this price, both the JUL 35 put and the JUL 40 put options expire in-the-money. The long JUL 35 put has an intrinsic value of $500 while the short JUL 40 put is worth $1000. Selling the long put for $500, he still need $500 to buy back the short put. Subtracting the initial credit of $100 received, his loss is still $400.

Note: While we have covered the use of this strategy with reference to stock options, the iron condor is equally applicable using ETF options, index options as well as options on futures.

Commissions

Commission charges can make a significant impact to overall profit or loss when implementing option spreads strategies. Their effect is even more pronounced for the iron condor as there are 4 legs involved in this trade compared to simpler strategies like the vertical spreads which have only 2 legs.

If you make multi-legged options trades frequently, you should check out the brokerage firm OptionsHouse.com where they charge a low fee of only $0.15 per contract (+$4.95 per trade).

Similar Strategies

The following strategies are similar to the iron condor in that they are also low volatility strategies that have limited profit potential and limited risk.

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