I am pretty baffled with the profit to loss ratios on long spreads and long naked options. Example: XLF (currently at $16.51) Jan 2012 puts: $11- .35 $12 - .46 . $15- 1.16 $16- 1.57 For a long naked $12 strike option, it is about 3.4 times at $16 (1.57 / .46 = 3.4). If I bought a long spread at the same $12 strike which I would only risk 0.11, it would be roughly about 3.7 times at $16... (.41 / .11 = 3.7) I've compared a few other stocks and it seems to me that the profit to loss ratio is almost the same thing. So why hedge with a spread? Especially, when naked options actually have a higher profit potential...? What am I missing here?
i could be wrong so "bare" with me. dont say naked when talking about long option positions. it just scares and confuses the hell out of everybody involved as evidenced by howards comment. you dont have unlimited risk with a long position, your risk is what you paid. also the hedge you are talking about with the spread is a means to lower your entry cost. and it reduces your potential gain. if you feel strong about direction, the long option is the way to go, if you are not so sure, a spread might be better, less cost going in. also i follow your math, but i really dont understand what you are trying to prove by it.
I've been busted. I did not carefully read the content, only the thread title. And thus, my response.
For some reason, I thought any single option position is considered naked whether long or short... Perhaps someone should tell this guy that he is confused as I am: "long-only puts & calls subscription service" http://www.nakedoptionstrader.com Anyway, I just don't understand why many people recommend using a long vertical spread to hedge "risk" when the risk ratios are very similar to the single long position (except for the almost unlimited profit on the single position). Instead of buying 4 $0.10 long vertical spreads, I could just buy a single $0.40 option at the same strike with the same negative risk... Perhaps time decay works differently with long vertical spreads...?
1) Out-of-the-money, outright, put-option, purchases or spread purchases will be cheaper than the same option(s) done at-the-money. 2) To do a spread is merely cheaper than the outright. The expiration breakeven point is also closer to the current market.
As nazzd sez, doing spreads is cheaper , that's all... The price you pay, as you mentioned, is that your upside is capped.
You have compared the two strategies under only 1 possible scenario. I suggest you plug the two strategies into an option analysis software and play around with what happens to each position under different combinations of underlying price, time to expiration and volatility. As you try out different scenarios you should be able to see the differences and the reasons for using a spread vs straight long.
Decades ago, the norm was to call any single option position naked and clarify it with long or short. Today, the norm is that a naked option means short/ uncovered. So if you put a bunch of old timers and noobers in a room with cocktails, they congregate separately so they can understand each other
What you're missing is that you're mixing things up. Your topic title mentions the profit-loss ratios of spreads versus nakeds (long optons) but with your math you calculated the risk ratio of a long 16p to a long 12p AND the same for a long 16 put long to a long 12/11 put spread. Where's the profit calculation? All you have done is determine how many of the lower priced position you can do for the cost of the higher priced position. That's not risk/reward or PnL. It's just equivalent risk.