One reason to own spreads instead of direct calls or puts is to reduce your cost of option buying. A call option with a month to expiration and average volatility might cost you $2, but a vertical spread might reduce it to $1.00 when you buy a lower priced call ($2) and sell a higher priced call ($1). Not only does it reduce your costs, but it lowers the price level at which you will be in the money. Moreover, you suffer less of a time decay penalty. Ideally, the stock price at expiration will be at the higher strike price you sold and net you the full difference between the higher and lower option prices; in this case $1 (excluding commissions). Your ROI would be 100%. However, there is a significant tradeoff when using spreads versus just calls and puts. The downside is that your spread is hostage to the expiration calendar in order to extract the full value of the spread. If the stock price rises or falls significantly between the time you placed the trade and expiration, you might not get all the value you could if you had just made a directional bet. Here is an example: You bought a 30/32 bullish call spread at a cost of $1 with 30 days until expiration with a maximum profit of $1 or a 100% return. The stock is at 30. Over the next week, the stock then surges in price to 32, but your spread only increases by 50 cents. This is because while you're making money on your lower priced call, you're losing money on your higher priced call. The higher price call you sold still needs time in order for you to receive the full credit. Alternatively, you bought a 30 call for $2 and it rose to $3.50 when the stock hit 32 because there is still plenty of time value left in the option. If you decide to preserve your unrealized gains, you could put a stop loss limit order at $3. Now, you can let the option ride while still coming out of the trade with a sizable profit. With a spread a stop loss order becomes more problematic. If you place a stop loss limit order at 40 cents, the daily volatility can easily trigger it. You wind up with a reduced ROI because time is still a factor in lowering the price of the spread. If you make the decision to led the spread ride to expiration, you can wind up with smaller gains or even losses when you could have protected yourself under the alternate scenario. This comes into play when the stock moves in your favor, in this case higher, during the middle period between when you bought the spread and expiration. The spread rises in value, but only a fraction of what you could realize ultimately if the stock holds its price at expiration. The downside occurs when the stock the falls from its peak, but there is still plenty of time left until expiration. If the stock rises from 30 to 32 at 23-Exp (23 days before expiration) the spread might rise from $1 to $1.50. However, if the stock then declines to 31.25 at Exp, you wind up with a 25 cent profit or 25% ROI instead of what you could have obtained if you had just bought the call and used the stop loss order ($1 at a cost of $2 or 50% ROI).
Thank you, your post is thoughtful. But I think I am missing what your main point is. Do you suggest that outright purchases and superior to spreads? Or maybe you are discussing the pros and cons, with no particular conclusion?
I am discussing the tradeoffs. You have to be aware of them and not assume using spreads get you something for nothing.
Good explanation of the tradeoffs of a spread vs a long call. Options involve a lot of moving parts (price, time, etc.) and the comparative performance will depend on where the components are. Your example is one snapshot in time and price. If the stock didn't move up as much or moved up more slowly or dropped, the spread might outperform (keep up/lose less). Another factor is IV. It can affect the comparative performance as well. While it's an unlikely event, a large enough IV decrease can make an equal dollar spread investment outperform the long call. Tho a non sequitur, for noobs, I'd stress the importance of spreads in lieu of naked options. Blow up slowly
I have a problem with debit spreads mostly, but can justify credit spreads if the circumstances are right.. trading deep in the money options are a better bet IMO if you are good with getting direction right (is anyone?) .. no need to let things DRAG OUT painfully till expiration.. and no 2, 3, 4 bid/offers to battle out, either.