Verticals - calls vs puts

Discussion in 'Options' started by CloroxCowboy, Mar 3, 2009.

  1. Last night I was re-reading a section of "Options as a Strategic Investment" where McMillan recommends using bear put spreads versus bear call spreads. His reasoning is that 1) the put spread should accrue more value than the corresponding call spread on a quick underlying move and 2) early assignment is not a concern since the short put is deeper OTM. That makes sense to me, but I was hoping to get some other opinions. I feel like his analysis is glossing over a few points that seem significant to me. What about cost of carry differences? Even the subtle psychological differences in starting from a credit vs a debit? Also, does this bias hold the same weight for a bull spread? The book implies that a large part of the bear put spread's advantage comes from a favorable IV skew.

    On the one hand, I'm moving to thinkorswim and their exercise/assignment fee ($15) is not trivial compared to $2.95 to sell the short option. It would be nice not to have that extra worry about early assignment hanging over my head.

    Of course there's no "right" answer, depends on the situation, etc, but I'd still like to hear any thoughts or opinions from those who have tried both.
  2. 1) European style index options canot be exercised prior to expiration

    2) IB charges zero for exercise/assignment

    3) If you can buy the put spread for a specific price, say $3.00 for a 5-point spread, and if you sell the call spread with the same strikes for $2.00, the profit potential is the same.

    But cost of carry is real. Do not ignore it.

    4) FORGET that psychological difference. that's poppycock. If the positions are equivalent then they are equivalent. But don't ignore cost of carry. that's real.

  3. Thank you Mark, good points.

    Would the other part of the argument - that bear put spreads should accumulate value more effectively than call spreads on a quick move in UL - mean that a put spread at $3 and call spread at $2 are actually not equivalent? For instance if the stock drops 20% in a few days...or is that supposed advantage already priced into the put spread in most cases?
  4. It is IMPOSSIBLE for one spread to accumulate value more quickly than another.

    If options get mis-priced the arbitrageurs come in and make money until the relative prices get where they belong.

    If the put spread rises to $4, the call spread falls to $1. Look up box spreads to see why the price of the box is constant (when interest costs are deducted).

  5. Ok bear with me on this, I still feel like I'm missing something. I understand your point about arb'ing with a box spread if one side was more "valuable" than the other. Maybe you could help me figure out if I'm not getting the point of the McMillan example? Or if you disagree with his point, please help me understand your rationale for why it is incorrect.

    He says, " has been mentioned previously, put options tend to lose time value premium rather quickly when they go into-the-money." By that I think he's referring to the first chapter in the put section which says "...the pricing curve demonstrates the effect mentioned earlier, that a put option loses time value premium more quickly when it is ITM, and also shows that an OTM put holds a great deal of time value premium."

    BTW, sorry to quote all this, I'm sure you've probably read the book. It just helps me explain myself. :D

    So what he goes on to say is that a quick downward move in the underlying that brings the short put ITM will eliminate more extrinsic value than the short call in a call spread. He says that the call spread may even pick up some extrinsic value during a quick down move.

    So once again, I'm not trying to knock your advice. I'd just like to understand your points and why they seem to be different than McMillan's.
  6. 1) I needed the quotes. Have not looked at that book in many years.

    2) Puts lose time value when ITM because there's a point when it becomes right for the put owner to exercise the put (either to unload married long stock or earn short interest on the short stock). At that price point (price of the underlying) all time premium disappears and the put trades at intrinsic value.

    3) Thus, he is not wrong.

    4) But we are talking about the put <i>spread</'i> and the call <i>spread</i>,
    not the individual options.

    I've don't pay attention to these details in the real world because I know the arb opportunity is not likely to be there.

    Options have a theoretical value. But don't always trade at that value. If one of the four options of the box is bid too high, or offered too low, some computer will find that box and buy it or sell it.

    All that means is that no one is incorrect here. The ITM put can lose all its time value, the ATM put and call will gain time value, and the OTM call will be priced correctly to keep the box in line.

    I really do not see an advantage to buying the put spread over selling the call spread, assuming they are priced appropriately.

    Maybe someone else can explain this better. SPIN?

  7. Mark,

    Let me state at the outset that I don't know the answer and I'm just speculating at a possible explanation.

    When they go ITM, puts lose time premium faster than calls do. So theoretically, for a modest but reasonable down move (say a strike), the bearish put spread should outperform to the downside because the components will go toward parity faster while the lower short strike of the call spread will retain more time premium.

    But as you indicated, in the real world, the arb opportunity won't be there because if it was available, everyone wouuld be doing them all day long. So my guess is that you suggested the correct answer:

    "Options have a theoretical value. But don't always trade at that value. If one of the four options of the box is bid too high, or offered too low, some computer will find that box and buy it or sell it. All that means is that no one is incorrect here. The ITM put can lose all its time value, the ATM put and call will gain time value, and the OTM call will be priced correctly to keep the box in line."

    I would think that the only realistic avantages are getting the direction right :) and if you do, one spread has a leg that expires, saving you slippage and commissions on the way out.

    What we need is a Greeks specialist! :)

  8. Thanks both of you, now I understand. It's a theoretical advantage that may in fact exist in the real world sometimes, it just doesn't exist long enough for me to gain an edge from it due to computer (and maybe non-computer) arbs. In that case I do agree with Mark that credit spreads would be my preferred position due to carry costs.

    To Mark's other point, I would honestly rather be with IB than thinkorswim, but just can't commit $10K to options right now. As we established in a different thread, I'm still fairly green with options and I'd like to keep my accounts separate while I get my feet wet. I think I would be tempted to experiment too much with the IB account because the commissions as a percent of the total balance would be so low. With ToS, I can deposit the minimum $3.5K and I'm hoping the higher commissions and the possibility of a $15 assignment fee will encourage me to make smarter trades and think through open positions more carefully.

    Great explanations, thanks again!
  9. My $.02. If you have the funds, open an IB account and paper rade for a couple of months. You can set up bear put spreads and bear call spreads of equal value and even the same distance from the underlying--and watch it. A couple observations: real-time is different than theory. MacMillan doesn't account for wide spreads between the bid-ask. So even quick moves downward for the bear put won't yield you as much as you think. I have found that the only way to earn the full value of the spread is to allow it to expire or just exit the trade the Monday before expiration. On the other hand, quick moves downward will crush the bear call spread. You can get out of that and roll down and repeat. I have just found that bear calls proved to be more profitable than bear puts in this scenario. For a quick profit on a downward move, I suggest "ATM or slightly ITM covered puts." The underlying basically moves twice as fast as the short put. For example, suppose I short the ES at 700 and sell the P700 @ 30.00. If the ES moves downward 30 points, the short put will only go up about 15 points; therefore, you make a profit of 15 points. I wouldn't hold this to expiration especially after a huge move downward.