Why are vertical debit spreads (bull call & bear put spreads) not discussed much? Instead, it seems that Iron Condors & credit spreads are the preferred topic. When you consider the risk/reward ratio of a debit spread vs. a credit spread, especially if both of which are about 2 or 3 strikes otm, it seems that the preference would be a vertical credit spread because of the risk/reward. Considering how much the market has fallen, I'm considering combing a vertical debit spread (bull call spread) with a vertical credit spread (bull put spread) to help pay for the premium of the debit spread. If the market moves against me, then I can acquire the underlying asset at a bargain. I would probably limit this strategy to the RUT or SPY or DIA (or the futures equivalent). Walt
The reason you don't read too much about debit spreads and that most of us write about credit spreads is because THE POSITIONS ARE EQUIVALENT (see: http://blog.mdwoptions.com/options_for_rookies/2008/07/equivalent-posi.html). If you sell the 80/90 put spread, it has exactly the same risk/reward ratio, the same maximum profit, the same maximum loss as buying the 80/90 call spread - as long as the expiration is the same. You are referring to OTM spreads - but that's not relevant. Buying the OTM call spread is the same as selling the ITM put spread - except for the possibility of early assignment. And that annoyance disappears if you trade European style, cash-settled index options: RUT, SPX, NDX. Mark The Rookie's Guide to Options
thanks Mark, I've read on other occasions that they are equivalent; however, let me give an actual example with the RUT. If I buy a March bull call spread (470/480), then I'll pay about $5 with the possibility of earning $10. However, if I sell a March bull put spread (480/470), then I'll recieve about $5 with the possibility of losing $10. Am I missing something...? Walt
YES. The possibility is to turn your $5 into $10 - not to earn $10. Mark PS I hope you don't mind but I'm borrowing your original question for my blog.
I'm sorry Mark, you're absolutely right... the risk/reward is identical... in the scenario with RUT. And of course, there's no need to worry about an early assignment, as it's an European Style. I guess the real issue is that most folks talk about option transactions otm. Very rarely are itm option strategies considered/discussed, especially Iron Condors. What can you say... No Free Lunch... No problem - feel free to use it on your blog. btw... do you think it's feasible to earn a living (about $8k - $10k)by exclusively trading and managing risk with ICs (assuming about $100k of capital)? Walt
I assume you mean per month and not per year!!! Feasible? Yes. Likely? No Yes, iron condors can easily lead to months with >10% earnings. And it will happen with some frequency. But, you must remember that there will also be losing months and that makes it very difficult to maintain the average of your winning months. The more you try to earn, the greater the risk. I'm sure you recognize that. If you trade a 10-point IC for $1.00 then to make your 10%, you must hold all the way to the end. Holding that long adds extra risk. And when your target is $100, when you lose - ok, it won't be all that often - it can be a big loss, wiping out the profits of a bunch of months. If you trade an IC for $3.00, there's a much higher probability of losing - but if you buy it back at (pick a price) $1.50, then your profit is 15% and you will be out of the market part of the time and that's a great risk-reduction method. There's lots you can do to make the money you are asking about - but don't forget that there are going to be losing trades. I'd aim for less, if I were you. And don't get overconfident. When I began trading IC exclusively, I had 14 consecutive winning months. Then reality set in. Mark
There are some very important considerations one must evaluate when choosing to trade either a credit spread or debit spread. Despite the fact that these are equivalent positions, and that you can create directionally equivalent position using either calls or puts, there are some very key differences. Generally most traders will want to close a directional position prior to expiration (either at a gain or loss!). Because of that, you have to consider the impact of an increase or decrease in implied volatility on your spread. Generally credit spreads will benefit from a drop in implied volatility (making them cheaper to buy back). The opposite is true of debit spreads which are negatively impaired by an increase in implied volatility. Some spreads are more apt to be affected by the above than others and there are many factors that come into play such as the difference between the strikes on the spread and how far in or out of the money the spread may be but irrespective of that, It is not correct to assume the spreads have identical characteristics even if the risk reward profile is identical. C.J.
Wait a minute. If one benefits from a drop in IV and one is negatively impaired by and increase in IV...That's, uh, the same thing, right?
This is a misunderstanding. Whether or not a spread benefits from a drop in implied volatility depends on where the underlying is at the time. If the underlying is closer to the strike you are long, you are overall long vega. If the underlying is closer to the strike you are short, you are overall short vega.