Controversial Option Discussion Of The Day - Calls and Puts

OK this is from the blog. In the real world traders might have more diverse reasons and goals for trading naked puts/covered calls, but as I say, it's intended as a thinking exercise involving synthetics.

We know that we can create a synthetic long stock position with options, by buying a call and selling a corresponding put, so we can look at any stock position as having a long call and short put embedded within it.

We can then analyze the naked put option as a long stock position with the short call stripped out leaving only the short put. A covered call can be looked at precisely the same way, as you have long stock with the long call component stripped out, buy writing (selling) the call leaving only the short put, albeit synthetically.

Why would an investor/trader do this?

By implication, the investor is dodging the cost of buying unlimited upside (the call option premium) and electing to collect the premium available in the short put. He is implying that he doesn't believe the stock is going to appreciate in value more than the strike price, plus what the put option premium is going to deliver in the time to expiry. If he does believe the stock is going higher than that point, he is short changing himself.

He also (by implication) doesn't believe the stock is going to fall by more than the strike price plus premium collected, otherwise just stay out, or use a different strategy. However if the stock does fall past this point, at least the loss is less than long stock.

It is a bet that the stock price is going to stay in a range, and electing to collect premium rather than shoot for capital gain

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mazzatelli1000 said:

How about this timeless statement from a questionable character:
"Credit spreads are better than debit spreads because they...you guessed it bring in a credit to your account. Get paid first, ask questions later"

True or False and why

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BUMP. Because it's a great question.

wayneL said:

BUMP. Because it's a great question.

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Well for me the answer is true and thats because if your in credit it means you have a head start and something needs to go "against" you to lose. But a debit spread starts you off behind the ball with a debit and you need to have something go "for" you to gain.

In short credit = at the front of the race and if nothing changes you win.

In short debit = at the back of the race and something needs to happen for you to win....

Does this make sense or is it too late for me?

Its like saying you buy a property thats positive geared from day 1 (credit)
but buy a property thats negative geared from day 1 and your in (debit) the difference from the 2 is 1 is profitable from day 1 without any changes whereis the negative property needs a move in order to become profitable?

(P.S this is just illustrating the differences between credit/debit trades and not strategy's).

Please correct me if im wrong in anyway.

Ageo said:

Well for me the answer is true and thats because if your in credit it means you have a head start and something needs to go "against" you to lose. But a debit spread starts you off behind the ball with a debit and you need to have something go "for" you to gain.

In short credit = at the front of the race and if nothing changes you win.

In short debit = at the back of the race and something needs to happen for you to win....

Does this make sense or is it too late for me?

Its like saying you buy a property thats positive geared from day 1 (credit)
but buy a property thats negative geared from day 1 and your in (debit) the difference from the 2 is 1 is profitable from day 1 without any changes whereis the negative property needs a move in order to become profitable?

(P.S this is just illustrating the differences between credit/debit trades and not strategy's).

Please correct me if im wrong in anyway.

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Ageo,

I don't want to jump in too much on Mazza's question, but with a knowledge of the Greeks, you could analyze the put spread and the corresponding call spread with those Greeks (plus dividends and cost of carry/moneyness), to determine if the statement was true or false.

wayneL said:

Ageo,

I don't want to jump in too much on Mazza's question, but with a knowledge of the Greeks, you could analyze the put spread and the corresponding call spread with those Greeks (plus dividends and cost of carry/moneyness), to determine if the statement was true or false.

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Ahhhh yes those damn greeks again (back to learning about them).

cheers

wayneL said:

Yes good one Mazza. As a clarification, we're talking about identical strikes in the credit and debit spread, yes?

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Ooops
Yes that was what I intended, I'll rephrase below

wayneL said:

I don't want to jump in too much on Mazza's question

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Nah, its fine. I usually pull out too much verbatim to make any sense!! LOL

Sorry guys, the question again:
"Credit spreads are better than their debit spread equivalent because they...you guessed it bring in a credit to your account. Get paid first, ask questions later"

E.g. a bull call spread vs. bull put spread with the same strikes

mazzatelli1000 said:

Ooops
Yes that was what I intended, I'll rephrase below


Nah, its fine. I usually pull out too much verbatim to make any sense!! LOL

Sorry guys, the question again:
"Credit spreads are better than their debit spread equivalent because they...you guessed it bring in a credit to your account. Get paid first, ask questions later"

E.g. a bull call spread vs. bull put spread with the same strikes

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So my answer above was way off?

Clue ==>> premium collection doesn't necessarily involve a credit. :casanova:

Thanks for the question Mazzatelli (and WayneL). I had to hit the books again to try and understand. I'll try to explain.

Most people creating a credit trade think there are collecting premium if they see an immediate credit into their account. It is not this credit that defines the trade as a premium collection strategy. A credit trade may have nothing to do with premium collection. Premium collection is defined by the total theta of the trade. Theta or time decay is largest in the at-the-money options, so to collect premium one must be short (sell) the at-the-money option or the option (in the spread) that is closest to at-the-money.

Constructing an spread trade just for the initial credit is the wrong way to think about it, but I understand the lazy influence of greed. The vertical spread is a directional strategy but determining how best to construct your spread using calls or puts, that is another question for the experts. The better construction to trade your views of the future price movements could result in either a debit or a credit.

Yes, peter2 is very warm that the premium capture in a vertical is affected by time/synthetic time [implied vol].

cutz said:

Personally i reckon credit spreads are better as they seem to have a higher probability of success. I say this because i think it's impossible to predict where a particular underlying is going to end up in say 4 weeks time.

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Ageo said:

Well for me the answer is true and thats because if your in credit it means you have a head start and something needs to go "against" you to lose. But a debit spread starts you off behind the ball with a debit and you need to have something go "for" you to gain.

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Since mention of credit spreads, the natural default is to assume the otm configuration where one is short premium - i.e. Time decay works for the spread.

E.g. XYZ = 50
Bear call spread 55/60

If the stock falls, profit results.
If the stock stays still, profit results.
If the stock increases and stays below 55, it still wins.

I imagine these are the reasons for cutz and Ageo responses, that something needs to go against you to lose.

But consider the Bear put spread 55/60 [itm]

If the stock falls, profit will result [deeper itm it goes]
If the stock stays still, profit results [itm]
If the stock increases and stays below 55, it also wins. [the gain on the 60 put > loss on short 55 put]

This also needs something to go against you [i.e. large upward move like the otm credit equivalent], but it is a debit spread. The less time the better, just like the bear call spread.

Is there a reason why the credit received still better?

peter2 said:

Premium collection is defined by the total theta of the trade. Theta or time decay is largest in the at-the-money options, so to collect premium one must be short (sell) the at-the-money option or the option (in the spread) that is closest to at-the-money.

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If I am interpreting this correctly, you are describing the capture of short premium in a vertical.
But you can also be long premium and neutral premium via verticals as well.

mazzatelli1000 said:

Since mention of credit spreads, the natural default is to assume the otm configuration where one is short premium - i.e. Time decay works for the spread.

E.g. XYZ = 50
Bear call spread 55/60

If the stock falls, profit results.
If the stock stays still, profit results.
If the stock increases and stays below 55, it still wins.

I imagine these are the reasons for cutz and Ageo responses, that something needs to go against you to lose.

But consider the Bear put spread 55/60 [itm]

If the stock falls, profit will result [deeper itm it goes]
If the stock stays still, profit results [itm]
If the stock increases and stays below 55, it also wins. [the gain on the 60 put > loss on short 55 put]

This also needs something to go against you [i.e. large upward move like the otm credit equivalent], but it is a debit spread. The less time the better, just like the bear call spread.

Is there a reason why the credit received still better?

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It depends when you use the spreads. If you compare the debit and the credit that was held on until options expiry date, you will profit more from the credit spread.

If the share price at expiry is 1c less than $55:

Profit from credit trade is total premium received when spread was sold.
Profit from debit trade is 1c...


The other reason is (takes out the text book that an options premium consists of 2 things, intrinsic and time value. The intrinsic is the real value of the option, the excess premium is time value. The time value loses value exponentially as the option gets closer to expiry.

In debits, the value of the options get melted away.
In credits, the value that melts away is 'locked' in profit.

So in a situation that the share price goes above $55, and the trader decides to pull out of his losing trade before expiry:
The debit will be sold at a cheaper price
The credit spread will be bought back at a more expensive price MINUS the melted away value.

If you do the math, the loss on the credit ends up being less than the loss of the debit.

The force that goes against you in debit trades is time. The force that becomes your wings in credit trades is time.

Time is the premium collector.


Now back to wayneL's question regarding greeks,

wayneL said:

A call IS a put. A put IS a call.

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Imagine your own personal characteristics, eg like strength, agility, intelligence, etc. Similar to this option has greeks to represent their characteristics (theta=time, vega=volatility, delta=option value per underlying movement, etc). You know you are strong in certain situations, and weak at other situations. Same applies to options (puts are strong for bear market, but not bull market).

If the greek number is positive, then the trade will be profitable if what the greek represents is positive.

eg, if a delta of the trade is positive, the trade will be profitable it the share price movement is positive.

If the theta of the trade is negative, (eg, naked call, or naked put), the trade will be profitable the less time there is left to expiration.

If the delta is zero (eg, delta neutral), the trade will be profitable if the share price movement is neutral.

Now with any combination of options/shares, simple math would be to sum up the greeks from each option. So you add up all deltas to get the delta of the combined entity, add all thetas to get the theta of the combined option entity, etc. (Wayne please correct me on this if I'm wrong)

Eg, credit Bear call spread, has combined theta that is negative...

So in essence, what the synthetic calls and puts are about, is trying to create a combination of options and shares (or possibly any instrument), to create a combined entity that has the same greeks as a call or put.

A call can become a put and a put can become a call.

wayneL said:

Clue ==>> premium collection doesn't necessarily involve a credit. :casanova:

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Take heed the words of a master!!

investedz said:

It depends when you use the spreads. If you compare the debit and the credit that was held on until options expiry date, you will profit more from the credit spread.

If the share price at expiry is 1c less than $55:

Profit from credit trade is total premium received when spread was sold.
Profit from debit trade is 1c...

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You may want to check your calculations

Since the bear put and bear call spread at the same strikes are synthetically the same, the risk should be the same, otherwise arbs.

E.g. using arbitrary prices
1) The bear call spread receives $1
Total risk is $5 [width of the spread] less $1 = $4

2) The bear put spread costs $4
Total risk is $4

If spot trades below $55 on expiry by one cent:

1) The credit spread as you say expires worthless and you keep the $1 credit received

2) The debit spread will be ITM
The short 55 put is ITM by 1 cent [$55 - $54.99]- so represents 1 cent loss
The long 60 put is ITM by $5.01 [$60 - $54.99]
Total gain of the trade is $5.01 - $0.01 = $5
Less the debit of the trade = $5 - $4 = $1

Oh no!! This is the same profit as the credit spread

investedz said:

In debits, the value of the options get melted away.
In credits, the value that melts away is 'locked' in profit.

So in a situation that the share price goes above $55, and the trader decides to pull out of his losing trade before expiry:
The debit will be sold at a cheaper price
The credit spread will be bought back at a more expensive price MINUS the melted away value.

The force that goes against you in debit trades is time. The force that becomes your wings in credit trades is time.

Time is the premium collector.

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In my post, I showed that the debit spread also benefits from time. The less days to expiration so that the spot cannot trade up and threaten the short strike [55 put] the better. You can confirm this by observing theta for the debit spread above.

The myth continues about credit spreads. Like sirens, luring sailors in before dashing them against the rocks

This is why I have quoted Wayne's post up the top.
Premium collection does involve time, but so far there have only been descriptions of short premium [involving otm configuration] and a generic assumption that all debit spreads have time working against them.

peter2 said:

Premium collection is defined by the total theta of the trade. Theta or time decay is largest in the at-the-money options, so to collect premium one must be short (sell) the at-the-money option or the option (in the spread) that is closest to at-the-money.

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As stated before this is a short premium [time decay on your side] trade.
The debate whether to short atm/otm is another debate in itself

To add to Mazza's post, here's another handy thing to know. The Greeks Theta, Gamma and Vega are strike specific. That means that at a particular strike the above three Greeks will have a value that is irrespective of whether the option is a put or a call.

eg If the x strike gamma is y, the gamma for x strike call and the x strike put is the same, viz, both the call and the put gamma will be y.

That means that with vertical spreads, it does not matter whether it is a debit call vertical or the corresponding credit put vertical, theta (and gamma and vega) will be the same in each.

Though the individual values will be different, the sum of deltas will also be identical, because of the mathematical relationship between puts and calls.

Wayne you ever done video tutorials on options?

Sometimes reading advanced options can be confusing like hell.

All good stuff thow

An alternative credit spread:

ABC = $20

Bull put spread 25/30
- Short $30 put
- Long $25 put

ABC needs to move above $30 to be profitable!!

The synthetic alternative is the Bull Call spread 25/30
The short call [$30] is away from the money

Is the credit spread still good??

Have to agree with you there mazza,

Bull puts/Bear call credit spreads aren't better then equivalent debit spreads, but I’m still convinced appropriate credit spreads are the preferred option for trading options.

For example say a short butterfly, ABC = $35, IV ~ 20%, 30 calendar days out, 33/35/37. Looks more attractive than its opposite side, what do you reckon?

BTW, I haven’t tried this yet, still backspreading. ( I’m not even sure if technically I’m backspreading I just like holding more longs than shorts as a form of disaster prevention )

cutz said:

For example say a short butterfly, ABC = $35, IV ~ 20%, 30 calendar days out, 33/35/37. Looks more attractive than its opposite side, what do you reckon?

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LOL, why won't this question die!!
It seems there is clouded judgement surrounding the synthetic equivalent when a credit is involved.

I am referring to the synthetic equivalent that results in a credit.
You are referring to the OPPOSITE offsetting position

An example involving a long butterfly would be where assuming the same strikes 30/40/50:
1) The entire butterfly is composed of puts or calls [debit: +30c, - 40c, +50c - 1:2:1 ] versus;
2) The butterfly which is like an iron condor - short the bull put and bear call, with the short strikes the same [credit: +30p, - 40p, - 40c, +50c - 1:1:1:1]

The question is then is the fly for a credit better than the debit fly that has the exact same payoff?

mazzatelli1000 said:

LOL, why won't this question die!!
It seems there is clouded judgement surrounding the synthetic equivalent when a credit is involved.

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Sorry mazza,

I gotcha now, yep debit verses credit, same payoff, can't see the advantage of one over the other.

Perhaps the thought of a couple of grand in the hand today is more attractive than waiting around, ( assuming everything goes according to plan).

Cutz,

There is really no inherently better/best strategy, only strategies that best suit your specific view... even if your view is specifically non-specific.

The short/long butterfly (do you mean the natural or iron?) question depends on your forward view of price movement and volatility... and what you are trying to achieve...oh, and management - if/how you intend to metamorphose the spread as necessary. Is the stock going to boogy in the next month, or sit there like a bank of faded geraniums?

Back to the vertical discussion and synthetics - there is a very good reason for considering synthetic equivalents:

1/ You want to pick the cheapest strategy in terms of contest risk, you want the spread with the tightest bid/ask and the least number of commissions.

2/ There may be assignment risks that are higher in one spread than the other, e.g. cost of carry issues and upcoming dividends. For instance, if you are DITM with a short call as one leg, and the stock is going ex-dividend, you are almost certain to be assigned early on that leg. Avoid.

So the credit spread may not be better or worse on the face of it, but specific factors in specific circumstances may make one better than the other in practice.

Ageo said:

Wayne you ever done video tutorials on options?

Sometimes reading advanced options can be confusing like hell.

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I hear you, but no haven't done videos. Might be something I do in the future though.