Beginner asks: Sell a Call Spread? Buy a Put Spread?

Discussion in 'Options' started by brothertruffle, Mar 4, 2010.

  1. Hi All:
    Which spread should I open a position in?
    I'm learning about spreads and although both of the shapes are identical.
    What should I be looking at in determining whether I should initiate either position?
    Any books/links/article recommendations would be appreciated!
  2. MTE


    It doesn't matter as the two spreads are synthetically equivalent. However, generally, it's preferable to trade the OTM one as you may be able to get a slightly better fill.
  3. JPope


    I'm not sure how you can consider these equivalent. Compare risk reward ratios. You can lose much more selling that call spread.
  4. They're not equivalent. You want to be a net seller of premium when IV is historically high and be a net buyer of premium when IV is historically low.
  5. MTE


    Irrespective of the premiums the OP has in the screenshot, a short call spread and a long put spread (and vice versa) at the same pair of strikes have exactly the same payoff, and exactly the same greeks, so it makes absolutely no difference which one you trade.

    The OP has probably made a mistake setting those up on the analyze tab in thinkorswim.

    I just looked the two spreads up, the long put spread is .65 (mid), the short call spread is .40 (mid).
  6. The two spreads are eqiivalent. If you're bullish, sell the put spread instead of buying the call spread and vice versa if you're bearish. If you're right and the options expire OTM, you save on exit slippage and commissions. IV change has no relevance with these equivalents.
  7. I think there is some misunderstanding...

    Many people confuse the term PREMIUM. It is NOT the net price of the option, rather it SHOULD only be referred to as the portion of the option's price above it's intrinsic worth. This is a common misunderstanding in books and lectures - even among brokers.

    Hopefully this will help.

    An option price is broken down into two distinct and very different values.

    Intrinsic Value: It's intrinsic value and the extrinsic value. The intrinsic value is just the difference between stock price and strike price.

    Extrinsic Value (known as PREMIUM). This is the amount that the option is priced OVER its intrinsic value.

    NOTE: Intrinsic value is ONLY affected by the difference between stock and strike price. It is undisputed.

    Extrinsic value (aka Premium, or sometimes JUICE) is determined primarily by volatility and time.

    Increase time and the Premium increases, but not the intrinsic value.
    Increase volatility and the Premium increases, but not the intrinsic value.

    On expiration all PREMIUM is depleted and the only thing left is the intrinsic value or ZERO.



    Stock is 72.50
    70 call is trading 4.20

    Intrinsic value is 2.50 (stock 72.50 - strike 70)
    Extrinsic (premium) value is 1.70 (option price 4.20 - intrinsic value 2.50)

    If stock was unchanged at expiration the option would expire at it's intrinsic value and thus lose all the premium (1.70).

    Call/Put debit vs. credit spreads.

    It is possible to have a net debit spread and still be short extrinsic value (or short premium).


    Stock is trading 72.50

    You buy the 70 call for 4.20
    You sell the 75 call for 2.20

    You have paid 2 for the spread.

    However - are you LONG or SHORT PREMIUM?

    (bonus question: are you long or short volatility, theta)?

    If we break down the trade we quickly see that we are short premium.

    We bought the call for 4.20, but we already know that 1.70 of it is extrinsic value (or premium). Thus we are long 1.70 of net premium.

    We then sold the 75 call for 2.20, it is out-of-the-money so it currently does not have any intrinsic value, only extrinsic value (or premium).

    We are net short .50 in premium, by being long the 70/75 call spread for $2.

    At expiration if the stock closed at 72.50 (where it currently is) - we could collect .50.

    The 70 call would expire at 2.50 (we would lose the 1.70 in premium)
    The 75 call would expire at 0 (we would collect all 2.20 in premium)

    The difference being .50

    Put side of the equation:

    If bought 70 level put for 1.70 and sold the 75 level put for 4.70, we would collect $3 credit.

    Again - take a look at the net premium.

    70 level puts have 0 intrinsic value (since they are out of the money). So the 1.70 is all premium.

    75 level puts have 2.50 intrinsic value (put strike 75 - stock price 72.50). Thus the extrinsic value is 2.20 (put price 4.70 - put intrinsic 2.50).

    Again we are collecting a total of .50 in premium.

    Coming full circle.

    A long (debit) call spread and the short (credit) put spread are identical in risk/reward and also (more importantly) short premium.

    70/75 long call spread you pay $2 (debt) to earn $3 if the stock rallies to 75. It has .50 of short premium. If the stock closes at 72.50 you make .50.

    70/75 short put spread you collect $3 (credit) and will collect that if the stock rallies to 75, you would lose $2 if the stock falls to 70 (just like the call spread). Also just like the call spread if hte stock closes at 72.50 you make .50


    Their is volatility, options skew, dividends, and cost of carry (risk free rate) - that makes the above example considered very simple. However, in principal - call/put spreads are the same risk/reward - no difference.
  8. Premium


    I'm not sure whether you're saying what the definition of premium is or what it should be, but as far as I know the definition of premium, as it relates to options, is the cost/price of the option.

    I understand what you're saying with regards to the generic definition of premium - as something extra or over fair value, but I would not use the term premium to mean the extrinsic value of options because the word premium already has a meaning in options.
  9. Aren't they similar or the same?
  10. OK, I'll bite.

    The Series 7 exam (for brokers) states that the OPTION PREMIUM is the amount that someone pays or receives for the option contract and is composed of two parts - extrinsic or time premium and if in the money, some intrinsic premium as well). Books by reputable authors say the same. Darn, even the Option Clearing Corp indicates this as well.

    You got the intrinsic and extrinsic part right in terms of components of the option's cost (dare I say premium?). You say otherwise, eg. that the extrinsic value is known as the PREMIUM. What's your source that refutes most of the world? :)

    #10     Mar 4, 2010