Choosing a New Options Spread
Steven Smith
09/24/04 - 02:36 PM EDT
In your experience, is it better to use debit and credit spreads on exchange-traded funds (ETFs) or stocks? I have been strictly a buyer of calls and puts, which worked well from 1998 to 2001, but I wanted to expand into basic debit and credit spreads. Any general strategies for spreads? -- JCF
This needs to be answered in a few stages. First, definitions. A vertical credit spread is the sale of a closer-to-the-money option (higher-priced) with the purchase of a further out-of-the-money option (lower-priced) with the same expiration date on a one-to-one basis. The profit is limited to the net credit or amount of premium collected and the loss is limited to the difference between strike prices minus the net credit.
Next, before getting to whether different strategies work better when applied to ETFs or stocks, it will be instructive to compare debit vs. credit spreads in general. The normal assumption is that a straight vertical credit spread is more attractive and will outperform a debit spread if volatility is high but is expected to decline. But in reality this is not necessarily true; both should perform the same.
The fact is, if you are utilizing the same strikes, a bullish call spread (a debit spread) and a bullish put spread (a credit spread) should be priced to present the same risk/reward. Otherwise, a risk-free arbitrage situation would be present, which market-makers would take advantage of. (See this article on
parallel positions and the concept of looking at the box spread for pricing options.)
As always with options, one should be looking to buy "cheap" options and sell "expensive" options. The very nature of a vertical spread, the simultaneous purchase and sale of related options, means that a change in implied volatility should have minimal impact on the position's performance.
Striking Out
Because spreads tend to be employed as directional or price-based positions rather than bets on volatility, they are usually established using out-of-the-money strikes. The further out of the money, the less profit potential a credit spread offers over its mirror credit spread.
For example, with the
Nasdaq 100 Trust(QQQ Quote) trading at $35, the November 36/38 call spread can be bought for a net debit of 55 cents, giving it a maximum profit of $1.45.
The November debit spread with the same strikes (sell the $38 put, buy the $36 put) can be sold for a net credit of $1.45 (which is also the maximum profit) giving it a similar 55 cents risk. These are essentially the same position and will produce the same profit/loss for any given price of the QQQ.
But the equidistant out-of-the-money credit spread, selling the $34 put and buying the $32 put, generates a credit of just 55 cents (which is the maximum profit) and has a maximum loss of $1.45 per spread. Clearly, as you go further out of the money, the debit spread offers the more attractive risk/reward.
Looking at the positions in the light of price expectations can help determine when a credit or debit spread makes more sense. Obviously, a credit spread makes sense if you believe the underlying price will fail to move into the money of the nearer strike price.
This is important in terms of profit, because the maximum profit on the credit spread can be achieved with a flat stock price in which all options expire worthless. The credit spread does carry the greater risk of early assignment by the option holder, which would present another set of risks entirely.
For the maximum profit to be made on a debit spread, the underlying share price has to move fully into the money, above the strike price of the option sold short. So credit spreads usually should be employed over debit for closer at-the-money strikes when the expectation is that price will remain relatively stable or you don't believe there is a high probability of the stock moving significantly against you.
Moving Up the Skew
Here's something beyond the basics. Moving beyond the basic price prediction, one can consider the skew (the difference in implied volatility as you move up the option chain) to determine if a credit or debit spread makes more sense.
In a normal skew, the lower-priced strikes will have a higher implied volatility, be it a put or call option. A vertical skew means that implied volatility increases the further out of the money you go. A vertical skew is uncommon in individual stocks; it will generally appear in high volatility situations around takeover rumors or impending news events. But a vertical skew is often seen in index products and occasionally on broad-based ETFs.
This is noteworthy only in that it presents a situation in which the debit and credit spreads have similar risk/reward but will have a
different vega (the expected change in an options value for one unit change in the implied volatility).
When volatility is high and there is a positive skew, it makes sense to use a credit spread because it will benefit from a decline in volatility. A debit spread expects a strong directional move and is not negatively impacted by an increase in volatility.
