Basic, I Know But Need Help On Bull/ Bear Spreads

Discussion in 'Options' started by paul19may, Dec 1, 2010.

  1. paul19may


    Just beginning with options so if this is too basic for this forum, please bear with me. (I have been trading stocks for 20 years or so, but am about 6 months new to options.)

    A 2 part question both to do with basic bull/ bear spreads:
    (1) What's the (dis)/advantage to a debit spread when the +/- diagram is the same for a credit spread (ie why pay when I can be paid?)
    (2) Everything I read (so this is the theory side) suggests 1x ITM, 1x OTM either side the current market value (puts/ calls depending upon whatthe spread is), yet the practice I have noticed on several places seems to be 2x OTM (different strikes) which makes a bit more sense to me as the underlying has to move to get inside the spread although the premium earned (credit) would be less than 1x ITM, 1x OTM

    If this is more the sort of thing for another forum, appreciate you directing me to that.

    Otherwise, appreciate your erudite responses to such a basic, yet confounding, question.
  2. 1) If the spreads have equal P&L potential, then the main difference is assignment and commissions.

    For example, if you buy a spread and you're 100% wrong, you lose the premium. Done.

    But if you sold the equivalent spread and you're assigned then you have to deal with closing the subsequent equity position and you incur extra commission(s) and slippage. There's also a possible equity risk if you're long or short assigned stock on Monday morning and the long leg of the spread expired.

    If you sold the spread initially and you're 100% right, it expires worthless and you're done. No more commissions.

    2) Sorry, don't understand this question
  3. spindr0: I think he means, assuming IWM is 74.5, buying a 74 call and selling a 75 call, as opposed to buying a 75 call and selling a 76 call.
  4. Yeah, I think that is what he means as well - except that I think he is referring to selling a spread in this situation.

    To the OP:
    If XYZ is $47, I think you are saying you see examples that say sell the 45 call and buy the 50 - in practice you see sell the 50 call and buy the 55.

    Either can be done of course, it is just risk/reward ratio. Alot of traders I think like doing the 2nd method where both strikes are OTM, because they can be wrong by in this example 3 points at expiration and still make 100% of their profit.

    In the first example, the trader would be more aggressively betting the stock would fall from $47 to less then $45 - in the second example they are just betting it won't go over $50. So, the second in theory is more likely to work with less reward upfront.

  5. MTE


    (1) It's not better to be paid than paying. There is absolutely no difference. If you sell a spread and get paid then you also have a margin requirement so you still end up tying up capital. Unless of course you use other securities to meet the margin requirement, such as treasuries or something.

    (2) The position of the strike prices relative to the price of the underlying depends on what you are trying to achieve and how aggressive you wanna be.
    - If you buy an OTM spread (mind you this is the same as selling an ITM spread) then you want and need the underlying to move your way. This spread is likely to have a high reward relative to risk, while the probability of achieving that reward would be low.
    - If you buy an ATM spread (same as selling an ATM spread) then the underlying has to move your way, but not by much. This spread is going to have a relatively even reward to risk ratio and the same goes for the probability of profit vs. probability of loss.
    - If you buy an ITM spread (same as selling an OTM spread, which is more commonly used) the underlying doesn't have to move anywhere for you to make a profit. In fact, the underlying can even move slightly against you and you may still end up with max profit. This spread is characterized by a low reward relative to risk and high probability of profit.

    A rule of thumb for the 3 possibilities above is that you generally want to trade the OTM spread (i.e. selling an OTM spread rather than buying an ITM one, or buying the OTM spread rather than selling an ITM one) as the OTM options are generally more liquid and have tighter bid-ask spreads, so you are more likely to get a better fill.

    You should also read up on the Box spread. This is the relationship that holds together the calls and puts at a pair of strike prices. And this is where this "buying OTM call spread is equivalent to selling ITM put spread" comes from.
  6. I'll leave it to you guys to reply to what you think that the OP thinks he thinks :)

    As for margin on these equivalent verticals, it's the same either way. For example, a 5 pt. vertical with a 2:3 P&L. You can lay out 2 pts for the long call spread, have a 3 pt potential profit and have no margin requirement - or - You can receive a 3 pt credit and have a 2 pt margin requirement for the short put spread. Either way, it ties up 2 pts for the position. Same difference.
  7. paul19may


    THANK YOU to all the respondents. VERY useful.

    I did indeed mean what trefoil has put below. Forgive me for not being clearer.

    Very succinct and understandable answers, thank you.