One of the advantages of options over stock is that we can create spreads. You want to trade Amazon but you can’t fork out $300k for 100 shares, no problem!
We shall see that the Long Call Spread & the Short Put Spread are more or less the same thing when it comes to direction. It’s important to note that we’re talking about Deltas and volatility so sometimes one can be more suitable than the other.
The first thing on the agenda is to see how these are set up. Both are limited risk strategies and they yield a limited return.
Long Call Spread set-up
Buy 1 Call option and Sell 1 higher strike Call option
In the example below we’ve bought the 53 strike call and sold the 55 strike call. We’ve paid $57 for the spread and stand to make $143 should the stock comply and breach the 55 strike. And if it doesn’t the initial $57 (excl. fees) are all there is to lose.
You can think about it a bit like buying a Long Call. However, you either don’t think that the stock will go up that much or you’re happy to reduce the upside to lower the cost of the strategy.
The 53 strike call in the example costs $1.90 or a total of $190 which is considerably more than the $57 you pay for the spread. Actually the breakeven of the single long call is $54.90 which almost coincides with the max profit point of the spread.
Short Put Spread set-up
Sell 1 Put option and Buy 1 lower strike Put option
This time we’re selling the options instead of buying them. We’ve sold the 50 strike put in our $50 theoretical stock and bought the 47 strike put meaning we’re very bullish.
The maximum profit is the premium we collected, $135, while the maximum loss is the width of the strikes minus the premium. It adds up to $300 – $135 = $165 (excl. fees).
It’s similar to selling a naked Put, however, we’ve decided to cap our downside by buying the 47 strike put. This will protect the position against any sharp down moves.
At this point you may be thinking that the Long Call Spread is superior due to the lower max loss but we shall see that my example is slightly deceiving. The volatility will guide us!
Choice of Spread and Strike
Here comes the difficult part! Both spreads benefit from appreciation of the share price so our directional assumption comes first.
Then you need to decide whether to play the put side or the call side. The first thing to consider is the implied volatility. If the volatility is high the options premium will be inflated.
You may be better off selling the options via a Short Put Spread. However, you need to make sure you collect at least 1/3 of the width of the strikes to justify the risk. This means a minimum of $1.00 (total of $100) for a 3 dollar wide spread or $1.67 for a 5 dollar wide one.
What if you can’t get 1/3 of the width of the strikes? Implicitly, the volatility is low and the options premium is low. That’s when you may choose to buy the Long Call Spread.
We have to be careful with volatility assumptions. They say it reverts to the mean but no one knows when exactly and options have duration to worry about. Consequently, it may already be high but there’s nothing to prevent it from shooting even higher.
There was a rumour that volatility is dead at some point, let’s just say Credit Suisse found out it’s still around.
Strikes & Width
There are no hard rules but the closer you are to the money the higher the chance of success of the Long Call Spread and the higher the premium for the Short Put Spread.
Unfortunately the risk is higher too, either to lose the premium you paid on the call side or to realise the max loss on the put side.
In terms of the Short Put Spread you can go as further away from the money as you want as long as you collect 1/3 of the width of the strikes. You can go all mathematical and start calculating the premium against the probability of profit. This may work but you’ll rack enormous fees and still have similar risk.
The Long Call Spread situation is slightly different. We can get a cheap spread, for $0.03 (total of $3) or similar, but the odds of making money out of it are pretty slim.
How wide should the spread be? How long is a piece of string? One way to design it is based on the amount you pay or receive a.k.a. the risk of the trade.
Another is to evaluate your directional assumption. You’re very bullish, you may want to set up a wider spread to capture more of the upside.
One technical difficulty is getting your order filled. It’s hard to get a fill on a 50 cent or $1 wide spread. Some strikes are more popular than others and you may find that there are no takers for the 43-44 strike spread. There may be some for the 40-45 one. It depends on the liquidity of the options and supply and demand.
Make sure you get a good price, frankly you’re better off trading something else than overpaying.
These are fixed risk-return strategies so you don’t have to worry about the Greeks that much. Having said that the spreads will behave in a similar manner as their single legged cousins, the short put and the long call.
Delta & Gamma
We’ve just added an additional leg to cap our downside. The consequence is that we tame down the Greeks too.
So our aggregate position will have 47 – 32 = 15 Delta and 5 – 5 = 0 Gamma. We may be short Gamma on the put side but that doesn’t matter because we have a built-in stop loss by the addition of the lower strike long put leg.
However, on this occasion the position is Gamma neutral at set-up. In reality you’ll be either short or long Gamma.
What happens when the stock moves? If we go back to the theoretical stock, a $2 up-move around 15 days to expiration will increase the value of your Long Call Spread to $67. This is in contrast with a single long 53 strike call, which would have lost $33 of the original $190 due to time decay.
Similarly the value of the Short Put Spread will decrease to $79 yielding a paper profit of 135 – 79 = $56. That is unless the volatility doubles.
The Short Put Spread has a directional advantage over the Long Call Spread because you make money if the stock trades flat. However, you ‘pay’ for this via the higher max loss.
Theta & Vega
The Long Call Spread will lose money to time decay while the Short Put Spread will be hurt by a volatility increase and vice versa.
If the volatility in the example goes down from 50% to 20% over the course of 20 days and the stock goes up to $52 the Long Call Spread will still be worth around $34. Compare that with the 53 strike call which will go down from $190 to $44.
You have to be aware that the Long Call Spread does benefit from a volatility increase but you won’t make a killing. If the volatility doubles and we keep the above assumptions we’re looking at a profit of 78 – 57 = $21.
The Short Put Spread situation is slightly different because it will gain from time decay and a volatility decrease. We’re looking at a profit of 135 – 20 = $115 while using the same assumptions. An increase in volatility from 50% to 100% will result in a P&L of 135 – 121 = $14. However, the stock has gone up by $2 so you only have to wait and observe subsequent developments.
It’s a fixed max profit & loss position so the management is somewhat integrated at set-up. Nevertheless, we all like to try new things to see if we can squeeze the odd dollar out so it’s always worth looking into different approaches.
Short Put Spread
You can just leave it to expire worthless. The benefit is that you collect all of the premium at the cost of risk, including the Gamma risk I talked about in the short put section.
Sometimes stocks can be unpredictable and you don’t want to turn a winner into a loser over $10.
This leads us to option 2: close it at some profit target. It can be anything, 30%, 50%, 75%. It’s up to you but you have to consider the fees you pay. There’s no point in making $20 per spread while paying $2.50 in commissions and fees.
Long Call Spread
We’ve paid money for this so if it’s not going anywhere I’ll let it expire worthless. Who knows the stock may explode the last day and recover some of the loss.
It is harder in terms of winners. You’ve made 100% profit, do you leave it? This is the dilemma of turning winners into losers all over again. Personally, I’ll shut it down if it’s made a decent dollar. I don’t want to leave it just to see the stock tank 3 days later.
Either way you have to do whatever suits you best!
Assignment, Expiry & Defence
The main reason not to leave a short spread to expire worthless is because the stock may end up between the two strikes. Options expire on Friday and it doesn’t matter if you exercise the long leg or leave it. You may regret it either way. There are also assignment fees no one likes.
Assignment risk and fees
Assignment is rare but it can happen. Your short leg was assigned, what do you do? In most cases your broker will give you a day or two, even if you don’t have the money, to figure it out. There are a few pitfalls though!
You may incur margin fees, something like $120 to hold 100 Amazon shares for 2 days. Sometimes the overall market volatility is high so the broker may shut down your position immediately. And then we have the hard to borrow fees on the call side. You don’t have to worry about these on the put side because you’ll be long stock.
The hard to borrow fees can be up to 200% or more per year. In the Amazon example that would be over $3k for 2 days but it’s still $22 to rent a $50 stock at 80% for 2 days.
You can exercise your long leg and the problem is solved, bar the fees. Assuming you have money in your account and you’re not short hard to borrow stock you can give it a few days to see if you can make a profit from the stock position. When the market gives you lemons make lemonade!
If you make a profit close the stock position and sell the long option leg. And if you don’t make money from the shares you can always close to stock position and sell the leg or keep the stock and exercise it. Whatever the case don’t panic! If in doubt call your broker, they’ll help you out!
Some advocate rolling a losing Short Put Spread for a credit. You can try that if you want as long as you are aware that you are closing a position at a loss. Then you open a brand new one. It’s the same as trading something unrelated.
In terms of fees and assignment you may choose to close the spread at a loss. For example, it’s a Short Put Spread, deep in the money, you can’t see it going anywhere, you want to close it down.
The only problem is the liquidity of the options. You may need to pay slightly more than the max loss. It’s ok as long as you pay less than the assignment fees. Again talk to your broker if you have any problems, they deal with stuff like that all the time.