In Search of Credit Spreads

On Wednesday, with Martha Stewart trading at $26.45, one can sell the April $25/$30 call spread for a net credit of $2.15. This represents the maximum profit that would be achieved if MSO is below $25 on the April 15 expiration day. The break-even point is $27.15 and the maximum loss is $2.85. But based on the delta of the position, it has a 65% probability of turning a profit.

Compare this to buying the April $30/$25 put spread for a net debit of $2.90. It has the same risk/reward, which is a maximum loss of $2.90, and a slightly greater maximum profit that is equal to the credit call spread, and a maximum profit of $2.85 but has only a 59% probability of achieving a profit. If one bought the March $25/$20 put spread for a net debit of 90 cents, the maximum profit is $4.10 but the probability of achieving any profit drops down to just 28% based on the current delta.

Think Inside the Box

In looking at these prices, you should notice they present a basic mirror image in terms of pricing and risk reward. Probably the most fundamental way to understand the relationship between various strike prices is to look at something called the box spread. While the box spread's implications come intuitively to some people, it's not a simple concept to grasp. Not being mathematically oriented myself, I still struggle with divining its implicit message of highlighting the mispricing, or "out of line" valuation, of specific options.

A box spread is a four-sided option play that involves a long call and a short put at one strike price, as well as a short call and a long put at another strike price. Essentially, this creates both a synthetic long position and a synthetic short position using different strike prices.

If all option prices are "in line," a box spread represents a riskless position. For example, let's assume ABC Corp. is trading at $52.50 and you buy the 50/55 box, meaning you sell the $50 call and the $55 put and buy the $50 put and $55 call. If all strikes are trading at parity, or in line, this should net you $5, because you're creating a synthetic short at $55 simultaneously with a synthetic long at $50. At expiration the position must be worth $5. This relationship holds true among all strikes, so the 45/55 box is worth $10, just as the 50/60 box should be worth $10.

Once you understand this dynamic, if you're given the prices of three strikes, you can determine the fair value of the fourth piece of the box regardless of the price of the underlying stock. This helps you recognize when any one option price gets out of line; it can be bought or sold, then hedged using the other three strikes to create a risk-free arbitrage situation.