- There's much more to options than just buying or selling calls and puts
- Investors can build tailor-made strategies to suit their needs
- It makes sense to buy only what you need
- Spreads are popular, as they can reduce the cost of the option
By Gary Delany
When investors or hedgers first look at options, they – rightly – look at them in the simplest way. They look at buying and selling calls or puts, the four basic strategies. But options offer more permutations than is the case when you simply buy or sell an underlying security.
With options, you can trade in, at, or out-of-the-money. You can trade them for different expirations. You can combine long and short positions. All these variables in an option’s profile enable the investor to construct a strategy that suits her needs.
Relatively straightforward combinations of options can, for example, enable the investor to get an extra income stream from his equity holding (write covered calls); to buy some protection for an underlying position (buy puts); to put a floor under his position and a ceiling above (sell out-of-the-money call, buy out-of-the-money put: also known as a collar); to buy a put and a call at the same strike price and expiration month (straddle), anticipating a move in volatility or price; or to buy a call at a lower exercise price and sell another call at a higher exercise price, for the same month (vertical spread), anticipating a limited upward move.
This article looks in more detail at spreads.
Suit yourself. There's no need to settle for a basic approach when you can build a tailor-made options strategy that matches your needs and preferences. Photo: iStock
Only buy what you need
For the option buyer, the put or call options purchased confer rights (for the option seller they incur obligations). The more you pay, the more you get in terms of price advantage: an in-the-money call option is more expensive than an out-of-the-money one, because it enables you to buy the underlying security or index at a lower price.
So it makes sense not to buy more than you need. Let’s look at a fictional example with the underlying stock at 100. The investor believes that the stock will rise 10%. So the investor buys a 100 strike call option for 60 days’ time and sells a 110 strike call. The underlying security is the same, the maturity is the same. Only the strike price is different.
If the investor’s view on the market is correct, she will be able to buy the security at 100. She will be able to participate in any upside move until 110, where her gain is capped because she has sold the 110 call. If the investor is wrong and the price of the underlying falls, then the net premium paid (the cost of the call bought less the income from the call sold) is the most that can be lost.
Spreads are popular because they can reduce the cost of the option. They are often the preferred ‘first trading tool’ for beginners because there is limited risk.
Vertical, horizontal and diagonal spreads
Investor find these terms confusing. Here’s a simple way to remember them. Look at the typical graph below.
In a vertical spread, we are looking at two options with different strike prices – just like the vertical price axis in the chart. For a horizontal spread we are looking at two options with different expirations, just like the horizontal time axis above. For a diagonal spread it’s a mixture of the two.
A vertical spread focuses on price moves using options that expire at the same time but with different exercise prices. A horizontal spread uses options with the same strike but different expirations.
Spread strategies seek to make money from moves in the different components of an option’s price. An option’s price is determined by:
- Exercise price
- Price of underlying security
- Time to expiration
- Interest rates
In the case of a vertical spread – two options with different strike prices but the same expiration – the investor is looking to profit from moves in the underlying price relative to the exercise price.
In the case of a horizontal spread – two options with the same strike price but different expirations – the investor is looking to profit from the relative impact of time. The rate of time decay of an option steepens the closer you get to expiration. The length of time between today’s date and the expiration date also represents the time frame left for an option to become more (or less valuable).
A look at leverage
It’s interesting to compare buying the investment outright, buying a call or buying a call spread. Look at a hypothetical investment in stock XYZ, below. This example does not include fees or commissions.
The 60 Call is bought at $5.50.
The 60-70 call spread involves buying the $60 call at $5.50 and selling the $70 call at $2. The net cost is then $3.50.
In the example, if the investor buys the stock at $63 and it rises to $70, he will make $7 profit. He will continue to make a profit if XYZ stock rises further. This needs to be balanced against the fact that he has paid for the stock in full. His percentage return on investment is 11%.
If he buys the 60 call and the stock rises, then his breakeven point is $60 plus $5.50 equals $65.50. If the stock rises to $70 by expiration, he will make $70 minus $5.50 equals $4.50.
If the stock rises above $70 before expiration, his profit will rise further. His percentage return on investment is 81% with the stock at $70.
If he buys the 60-70 call spread for a net cost of $3.50, then his breakeven price is $63.50. If the price rises to $70, his profit will be $70 minus $60 minus $3.50 equals $6.50. He will not participate in any gains above $70, as he sold a $70 call. His percentage return on investment is 185%.
Debit and credit spreads
The example of the 60-70 call spread above is a debit spread. It costs you money because you are building it with call options. An alternative is to build a bull put spread with put options. A bull put spread involves being short a put option and long another put option with the same expiration but with a lower strike. The short put generates premium income. The long put offsets assignment risk and gives protection in the case of a sharp fall in the price of the stock. Because of the relationship between the two strike prices, the investor will always receive a premium (credit) when initiating such a position.
This strategy entails precisely limited risk and reward potential. The most this bull put spread can earn is the net premium received at the outset, which is likeliest if the stock price stays steady or rises. If the forecast is wrong and the stock falls instead, the strategy leaves the investor with either a lower profit or a loss. The maximum loss is capped by the long put.
Comparing the bull put spread with the bull call spread, the profit/loss payoff profiles are exactly the same, once adjusted for the net cost of carry.
The main difference is the timing of the cashflows and the potential for early assignment. The bull call spread requires a known initial outlay for an unknown eventual return. The bull put spread produces a known initial cash inflow in exchange for a possible outlay later on.
For more information:
The Options Industry Council (OIC) is an educational organisation funded by OCC, the world’s largest equity derivatives clearing organization, and the US options exchanges. The mission of OIC is to increase awareness, understanding and responsible use of exchange-listed options among a global audience of investors, including individuals, financial advisors and institutional managers, by providing independent and unbiased education combined with practical expertise. Learn more about OIC at www.OptionsEducation.org.
The opinions expressed are the author’s own.
Options involve risk and are not suitable for all investors. Individuals should not enter into Options transactions until they have read and understood the risk disclosure document, Characteristics and Risks of Standardized Options, which may be obtained from your broker, from any exchange on which options are traded or by visiting www.OptionsEducation.org. None of the information in this post should be construed as a recommendation to buy or sell a security or to provide investment advice. ©2016 The Options Industry Council. All rights reserved.