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)

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Options Education Series - Part 1 : Three Ways to Capitalize On Options

You will reduce your risk if you take your 500 shares of ABC stock, sell them, and then buy five ABC call options that are a few strike prices in-the-money.

Example:



If ABC is at $60.00/ share, and you pull up the option chain and look at the 2009 January calls, you might see these call options available:



2009 January 60 calls trading at $9.00    (These are at-the-money)


2009 January 55 calls trading at $12.00  (These are one strike price in-the-money)

2009 January 50 calls trading at $15.00  (These are two strike prices in-the-money)

2009 January 45 calls trading at $18.50  (These are three strike prices in-the-money)



It makes more sense to buy five of the 2009 January 45 calls at $18.50 (for $9,250.00)instead of buying 500 shares of ABC stock at $60.00 (for $30,000.00).  THEN, put the remaining $20,750.00 in a money market account and earn 5%.




The intrinsic value of the option is $15.00 (because the stock price of $60.00 minus the strike price of $45.00 = $15.00) and the extrinsic value of the call option is the remaining $3.50 (because the call costs $18.50 minus $15.00 intrinsic value = $3.50).  That means that over the life of the call option (especially in the last few months leading up to the January 2009 expiration), that $3.50 extrinsic value (aka "time value") deteriorates.  That means that if your ABC stock trades flat at $60.00 for the next 16 months, the option would lose $3.50 and move to $15.00.




Keep in mind that the $3.50 loss (assuming that you actually held on for the next 16 months) is a loss of $1,750.00.  But since you put the rest in a risk-free money market account, you earned $1,383.33 interest.  So the loss is reduced to $366.67.  (And that would equate to 73 cents of the call option instead of $3.50.)



Now - what are you getting in return for your willingness to lose 73 cents over the course of 16 months on a $60.00 stock (which really only equates to 1.21%?)



#1) You know that your absolute MAXIMUM downside risk is the $18.50 (or $9,250.00) that you invested in the call option, instead of the $60.00 (or $30,000.00) on the stock which likely wouldn't lose all of its value, but as we know, a loss of anything between one cent and $30,000.00 is possible.



There are many benefits here that one wouldn't consider at first.  One of them is the psychological benefit.  I mean, you would be a lot less worried about the stock market crashing, for one. That would allow you to feel more confident when buying when people are fearful.  That means that you would be buying when things are down.




(Also, remember that you should usually play both sides of the market.  So you can also buy in-the-money put options to bet on the downside.  That means if the stock is at $60.00, and you were betting that it would trade lower, you would buy the 2009 January 75 puts.)



#2) If your stock moves higher, you are making almost the same amount that you would have made on the stock.




#3) If your stock moves lower, you are probably going to lose much less than you would have on the stock.  (A very basic hypothetical example is that if the stock trades up 10 points, you will probably make 9 - 9.5 points, but if the stock trades down 10 points, you will probably lose about 7 points.)  So you see, the downside vs. upside ratio is less than par.

You only get the downside vs. upside ratio benefit if you do two important things:



1) Buy the options that are in-the-money by a few strike prices.

2) Buy an option that has a long time until expiration day like the example that we used, preferably at least one year.  The ultimate goal is to be out of the position at least three months before the option expires.


Source:
          iStock Analyst

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Online Stock Option Trading News: Call Trading Picks Up on Visa Inc.

Visa Inc.
(V: sentiment,chart,options) was the center of some heavy options trading on Wednesday, as more than 53,200 contracts changed hands. This volume was more than three times the equity's average daily trading volume of 17,300 contracts, according to data from WhatsTrading.com. In addition, 66% of the volume changed hands on the call side. In the front three months of options, the most active strike was the November 75 call, which added approximately 1,300 new positions to lift its open interest up to nearly 2,300 contracts.

Overall, options players remain skeptical of the shares. The International Securities Exchange (ISE) continues to see a preference for puts over calls. The ISE 10-day put/call volume ratio comes in at 0.71, which is higher than 57% of all those taken during the past year. In addition, the Schaeffer's put/call open interest ratio stands at 1.14, as put open interest outnumbers call open interest among options slated to expire in less than three months. This reading is higher than 98% of all those taken during the past year. In other words, options players have been more skeptical of the shares only 2% of the time during the past 12 months.

Short sellers are also adding to their bearish bets. During the past month, the number of UNH shares sold short rose nearly 24% to 21 million. This accumulation of bearish bets is more than five times the stock's average daily trading volume and accounts for nearly 3% of the company's total float.

Source:
          Schaeffersresearch

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What Is Option Trading?

An option is a contract that gives the owner the right, but not the obligation, to buy or sell a security at a particular price on or before a certain date.
Investors buy and sell options just like stocks. There are two basic types of options:

• The call option
  
• The put option

The Call Option

The call option is the right to buy the underlying security at a certain price on or before a certain date.



You would buy a call option if you anticipated the price of the underlying security was going to rise before the option reached expiration. For example:

Company XYZ in trading at $25 per share and you believe the stock is headed up. You could buy shares of

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