More Options With Options

Article of the Week from Online Trading Academy

by Russ Allen, Online Trading Academy Instructor

In my last two articles, which you can read here and here, I wrote about the Collar strategy. This is a means often used by investors to buy low-cost protection for a long stock position.

Using an example with GLD, the ETF representing gold, I showed that the Collar (whose three components are a long stock position, a protective put, and a short call used to finance the purchase of the put) is equivalent to a bull call vertical spread. Both positions have limited risk and limited reward.

As of September 5, GLD was at $132.20.

Here are some option prices as of that date:

130 October Puts: $ 3.18

130 Ocotber Calls: $ 5.35

140 October Puts: $ 9.20

140 October Calls: $ 1.45

If we were still bullish on gold, we could have created a Bull Call Spread by buying the 130 Calls at $5.35, and selling the 140 calls at $1.45. The net cost would be $5.35 – $ 1.35 = $4.00. This net debit would be our maximum loss, and would occur if GLD was below $130 at the October 19 expiration date. In that case both the 130 and 140 calls would be worthless, and we’d lose our $4.00 investment.

Best case would be with GLD above $140 at expiration. In that case our spread would be worth exactly $10.00 (the difference between the 130 and 140 strikes). For example, if GLD were at $145, we could sell our 130 calls for $15, and we’d have to pay $5 for the 140 short calls. We’d put a net of $10 in our pocket. Since we paid $4.00 for the spread, our profit would be $6.00.

Our breakeven price on this trade would be $130 (the strike price of our long call) plus the $4.00 debit, or $134.00. With GLD at that price at expiration, we’d be able to sell our 130 put for $4.00, recovering our initial cost.

The payoff diagram for this bull call spread is below.

Figure 1 – GLD October 130/140 Bull Call Spread
Click to enlarge

We could have accomplished exactly the same thing with the Put version of the bullish vertical spread. Instead of buying the 130 call and selling the 140 call, we could buy the 130 put (for $3.18) and sell the 140 put (for $9.20). This would result in a credit to our account of $9.20 – $3.18 = $6.02. This $6.02 would be our maximum profit, and would be ours to keep if GLD closed on the October expiration at or above $140. In that case both of the puts would expire worthless, and we’d just keep the credit.

The payoff diagram for the bull put spread is below.

Figure 2 – GLD October 130/140 Bull Put Spread
Click to enlarge

With the put spread, If GLD were to be below $140 at expiration, then we’d have to pay some money to buy back the $140 puts, which would then be in the money. If GLD were to be at $130, then the 140 puts would be worth $10, while our long 130 puts would be worthless. We’d have to pay $10 to close out the position. That would consume our original $6.02 credit, plus another $3.98 of our money.

That $3.98 would be our maximum loss. At any GLD price below $130, our long 130 puts would begin to gain a dollar for every additional dollar the short 140′s cost us, so it couldn’t get any worse.

Since the maximum loss on this position would be $3.98, that’s how much of our own money our broker would require as margin to put on this trade.

Our breakeven price on this version of the trade would be $140 (the strike price of our short put) minus the $6.02 credit, or $133.98. With GLD at that price at expiration, we’d have to pay $6.02 to buy back the 140 puts, consuming our original credit.

Here’s a comparison of key stats for these two trades (per contract):

As you can see, the two trades are about as nearly identical as you can get.

Note that for bullish vertical spreads like these, whether they’re done with puts or with calls, we buy the low strike and sell the high strike. In the case of calls, we’re buying the more expensive of the two options and selling the less expensive; so we pay out money to enter the trade. We say we are long the spread, or that we have bought the spread. We eventually have to sell the spread at a higher price to make a profit.

When the vertical spread is done with puts, we’re selling the more expensive of the two options. We take in a net credit to put on the trade. Our broker, however, will keep that credit as security, along with an amount of our own cash equal to the maximum loss on the trade. In this case, we hope not to have to pay back any of the credit when the options expire. This will happen if both options expire out of the money and therefore worthless. In that case, our collateral is released when the options expire, and we have the use of the funds we put up as margin, along with the credit we received.

In summary:

• The Bull Call Spread and the Bull Put Spread are near-identical equivalents.
• The Bull Call Spread is done for a debit, which is its maximum loss.
• The Bull Put Spread is done for a credit, which is its maximum profit.
• With any debit spread, maximum profit occurs when both options expire in the money.
• With any credit spread, maximum profit occurs when both options expire out of the money.

With options, there are always multiple ways to accomplish a given objective. Knowing how to put together different combinations increases our flexibility and our ability to profit.