Why Buy Calls When You Can Sell Puts?

by Kevin Cook

A great question came to the ONN.tv virtual mail bag recently regarding iron condors and other credit spread strategies:

Do ITM debit spreads = OTM credit spreads? I notice a lot of traders have a preference for credit vertical spreads & iron condors. Aren’t ITM debit spreads synthetically equal to OTM credit spreads (e.g., AAPL 200/205 bull call spread & AAPL 205/200 bull put spread) and iron condors = to long condors? If that is the case – how does one choose which one to go with – i.e., the credit side or debit side?

I love this question because it really gets new option traders thinking about the basic mechanics of risk/reward with spreads, and about option synthetic relationships. On Oct. 27, I pulled up a quote chain for December Apple (AAPL) options so we could use real prices for the examples. With the stock trading around $197.50, the bid/ask premiums for puts and calls at the 190- and 195-strikes were:

190 Strike: call 13.50 ask; put 5.75 ask

195 Strike: call 10.50 bid; put 7.75 bid

Now let’s construct the in-the-money (ITM) debit call spread vs. the out-of-the-money (OTM) credit put spread. Both are bullish strategies with identical risk/reward characteristics and payoffs. In both, we want the underlying shares to stay higher than $195 to achieve max profit and avoid losses:

190/195 bull call spread debit is $3.00

Potential return on risk is $2/$3 = 67%

190/195 bull put spread credit is $2.00

Potential return on risk is $2/$3 = 67%

The fact that the spread premiums create precisely the same return is not surprising, even though traders may be able to get into these spreads for slightly better or worse prices that will affect which one they prefer. That said, they are still synthetically equivalent (a property of put-call parity relationships) and thus virtually identical in terms of risk/reward.
So, if the strategies are essentially equivalent, which is what makes synthetic option relationships work, which do you choose? It may simply depend on what type of trader you are. Here are a few reasons different traders choose among equivalent credit or debit strategies:
• For option traders who are only approved for buying options and spreads, they have few choices. Their broker or type of account may not allow any short or credit strategies. This may seem unfair if the strategies are equal, but that’s how options are treated to protect account holders and brokers.
• For active option traders, especially institutional professionals, it comes down to efficient use of capital. They are able to sell more OTM spreads and iron condors because they collect premium upfront, have minimal and/or offsetting margin collateral requirements (i.e., portfolio margining), and can earn meaningful interest on balances. Additionally, professional traders are often trading these synthetically equivalent strategies against long and short stock positions, capturing arbitrage profits from conversions, reversals, and boxes.
• For traders who focus on volatility strategies, they may prefer selling spreads and profiting from “overvalued” options and time decay, while trying to avoid ever paying up for options volatility. Theoretically, this volatility issue shouldn’t matter that much in equivalent spreads. But because they think “selling is better,” it dominates their strategies.
A final issue affecting all traders to various degrees is commissions from exiting spreads, or from exercise and assignment at or before expiration. If you sell the 195/190 bull put spread and it stays OTM as you had hoped, your options expire worthless with no additional commissions. But the 190/195 bull call spread staying ITM will require you to either exit before expiration and pay commission(s), or pay the commissions from exercise and assignment at expiration.

How to Practice for Free

Understanding option synthetic relationships and equivalent spreads launches your options trading expertise to a new level. If you still struggle with the concepts, you could pick up a book that explains put-call parity and synthetics.  You could also read my article in SFO Magazine from January of this year called, “The Balancing Act of Put-Call Parity.”
The best way to learn this stuff is to practice putting together the spreads yourself with tools that let you simulate their risk/reward profiles. For that, I can recommend no better tools than the OptionsHouse trading platform, which I use every day to build spreads and break down their dynamics. If you don’t have an active options trading account with OptionsHouse, at least open a free virtual one to try the great tools.
The Profit&Loss Calculator let’s you quickly assemble spreads just by clicking on the bids and offers in an option chain. It builds the graphs for you and allows you to watch their progression through time and changes in volatility. You can also quickly eliminate and add option legs and stock to the same graph.

When it comes to understanding the value and risks of options and spreads before you trade them, this kind of practice is priceless.

Source:
            Options News Network TV (ONN)