Why the Spread Beats the Long Call We are happy to start publishing here trading ideas and research prepared by our analyst, Richard Lehman. Rick is an options maven from the earliest days of exchange-traded options, starting his career on Wall Street the year the CBOE first opened its doors. He was a Regional Options Coordinator at E.F. Hutton and then the National Options Coordinator at Thomson McKinnon Securities, where he worked with options legend Lawrence MacMillan. Rick went on to write two options books and then developed and taught the Options course at UC Berkeley Extension for financial professionals. Among other things, he currently teaches an Options course at Cal Poly and trains the new hires at Parallax Volatility Fund, a hedge fund specializing in options trading. The Markets at a Glance Charts: IVolLive Charts: IVolLive The Trend Gets Another Boost From the Fed The market held ground on Wednesday while it awaited the latest announcement from the Fed on interest rates. But as soon as the Fed reiterated its stance on issuing several rate cuts this summer, the "all clear" was essentially sounded and the market lurched higher with lower implied volatility indicated by S&P options. Thus, the market continues in its 6-month trend and long positions in many stocks may be starting to give traders the jitters. As uptrends lengthen in time, they are commonly characterized by a broadening effect among individual stocks and sectors, causing traders to seek out stocks that may not have necessarily been leaders during the early stages of the rally, but may come to life as profits from the early winners are redeployed. One such stock might be First Solar (FSLR). A recent earnings report was positive, its valuation is reasonable, and it had been a lot higher before people rotated out of it. Perhaps it can see more interest in the coming weeks. Here's what the chart looks like: Charts: IVolLive Strategy talk: Why the Spread Beats the Long Call As someone who prefers to take home modest profits on a more frequent basis than swing for the fences and strike out most of the time, I prefer vertical or diagonal spreads over long puts or calls by themselves in almost all situations. Besides having risk-reward characteristics that are more aligned with my risk posture, spreads reduce the dreaded time value decay of long calls and the pressure to take a profit or loss too early as a result. In addition, there may be a perception by some that a spread is less desirable because it caps your profits. There is of course a cap with spreads, but the cap can easily exceed 100-200%, and it reaches that profit level at a lower price on the underlying stock. So is that necessarily a bad thing? What traders don't always recognize is the additional leverage, the lower breakeven point in the stock, and the wider range of prices where a profit will exist from the spread. Let's compare the two strategies on FSLR. If I decide to use a 150/155 call spread in the March 28 expiration (long 150 call and short 155 call), it will cost about $2.20 (based on Wednesday's closing prices). Purchasing the 150 call by itself would cost about $4.50. Below is a table of the results for prices on FSLR between 150 and 160 at expiration. Data: IVolLive The spread will max out at +127% profit but returns that amount for all prices above 155. The long call has a theoretically unlimited potential gain but will not return as much as the spread until the stock goes up beyond 160 at expiration. And the spread breaks even at 152.20, whereas the long call doesn't break even until 154.50 on the stock. The bottom line is that the call may be open-ended but will return less than the spread for a more likely range of near-term prices. And IVolatility Spread Scanner can help you compare the characteristics of many possible spreads in a flash, to help you zero in on the best one for you. Got a question or a comment? We're welcome your questions or feedback about the option strategies. If there is something you would like us to address, we're always open to your suggestions. By Richard Lehman, IVolatility.com
Hello Rick I like the basic premise of "Far From Random" and also prefer spreads although I am not currently active in options markets, preferring to trade Emini Futures. Like you I use Trend Channel Analysis, and have added my own twist to this by looking at the way that institutions put money to work at specific times of the year in anticipation of both high impact policy decisions and seasonal reporting (quarterly) requirements. I don't' have sufficient data yet to confirm a significant edge but I like the data evaluation process and am hopeful it will lead to something of value in future. Best of luck to you Steven
An excellent posting demonstrating the advantage of options spreads strategies. The table for comparison of the results for the two strategies is very convincing. Thx, Mr. Richard "Rick" Lehman and @IVolatility! Just two minor typo fixes: should be "March 28" (due to market holiday on March 29), and "long 150 call and short 155 call". And informal: such a spread trade usually requires a MarginAcct with Level 3 Options trading permission. In a CashAcct (incl. most IRAs) it's usually not possible (or possible only when using a CashSecuredPut for the ShortPut, but then the ROI% generally degrades, though still could be higher than that of the LongCall (this not checked yet)). The said trade setup could be like this one: https://optioncreator.com/st6hc5k
The above is incorrect. I was meaning when substituting a ShortCall by a CoveredCall, or substituting a ShortPut by a CashSecuredPut...
I see where you are going only if you plan on putting the trade on and holding till expiry. Other than that scenario,it doesn't make a ton of sense to compare a vert with a naked long call as they will have different deltas,as well as the obvious difference in cost of positions. I look at delta neutral to make a fair comparison between a vert and long call. There's more to it than that,but it should be a good starting point..Unless you only look at terminal payoffs. Either way,I would run a backtest
I quickly ran some 10 year backtests on SPY,comparing various option strategies with limited risk. No naked short puts,no risk reversals. Stuck to Naked call,Verts and Flys.The testing was down and dirty,didnt put much time into it.. As we know,a naked call costs more than a vert with the same long strike and a vert costs more than a butterfly with the same Long call lower strike and same short "guts". Does that imply one should buy the Fly over the Vert because its cheaper,or the Vertical over the Long call because its cheaper..Most likely not. Without handing out the secret sauce "for free" (due to idiots like Quanto),one obviously has to look at Implied vol ,skew and relative pricing...Of course ones directional bias comes into play,as well as forecasted terminal price range, but to think that one strategy has an inherent edge over the other is a very simplified view. There are relative sizing factors that should be accounted for,and unless one has an exceedingly accurate ability to forecast the future I would not say spread bets beat the long call in an up market. I wish it were that easy
Hey @Moderator, this @taowave idiot who has no clue of what he really is talking under this topic (he even hasn't grasped that it's not about SPY but FSLR !), is violating the forums rules, the Terms of Use, by unfairly publicly insulting other members. Such asocial users should not be tolarated b/c such negative behaviour of these sick users leads to situations like those under the sicko Destriero, when he let nobody else a chance to participate in a discussion, nor start a new discussion b/c that animal made everybody publicly down with very harsh words, so in the end even the sponsors had enough... @Baron, don't tolerate such idiots harming ET, just warn them either publicly or privately.... Just believe me that this guy belongs to the Destriero gang and has an agenda to harm ET!... By killing or watering down good discussions by posting useless off-topic spam trash... It's one of their preferred methods!... I have these scumbags blocked, and this is my right to do, and they are unhappy about it...
The table in the OP already clearly shows and proves everything claimed, ie. that the shown Vertical Call Spread (LongCall + ShortCall) is better than the LongCall alone. So what does this @taowave idiot not understand?
An analysis at a point in time is correct for that point in time. Market changes, price changes, IV changes.... He is a teacher, you sir are a trader. After a decade trading long single legs, I know who I put my money on. I do have to qualify my statement: I am just an amateur retail, trading my own money, not a professional trading OPM.
A big part of trading is comfort level.I happen to be a "spreader", though I lean toward ratios My main point was the scenario analysis presented was narrow in scope,with the stock trading in a tight band. One could easily come up with a split strike fly and have a much nicer P and L table for FSLR trading between 150 and 160. More to the point,I did run a simple backtest on the SPY over the last 10 years.It certainly wasn't exhautive,but it appears that 1 naked call outperformed the Vertical with the same long strike.Makes sense in a rip roaring Bull market. To each is own,but I wouldn't be so sure 1 spread outperforms a naked call. Which is why one backtests ..