In our quest to understand trading options for income, the topic of this article compares a Long Put position to a Put Debit Spread position to determine how we can improve the ROC (return on capital).
Last year Tasty Trade conducted a test using PCLN to determine why a long position, especially a Long Put, lost money when near expiration and ITM (in the money); even if IV expanded (which is helpful to a Long position).
The test was initiated by buying a June 830 Put with 32 DTE (days to expiration) on May 20, 2013 when PCLN was at $842.50. The cost was $1,955 (option price $19.55 x 100) and IV (implied volatility) was 25.28%. On June 17th, just a few days from expiration, PCLN had dropped to $828.50, below the strike price of the Put. With IV set to 30%, the current price of the option was $11.35; a loss of $820 (100 x (19.55 - 11.35)). Note: the actual loss on the 17th was $920, since IV was actually at 24.25%, slightly lower.
With the underlying moving in the right direction and IV increasing (per Tasty Trade's test), why the loss? Well, the reason is the decline in extrinsic value (often called time or risk value). When you buy an option (a Long position), theta (time value) is negative indicating that time is not helpful to your position. As you approach expiration and the price of the underlying (PCLN) is close to ATM (at the money, or the strike of the option), the daily loss due to time is near maximum. As Tasty Trade noted, the only way to salvage the position is if vega (tied to IV) dramatically increases.
So there are two factors affecting the Long Put position: theta (time decay), and vega (volatility). If we can minimize the impact of these two factors, would our position actually turn positive? To answer this, Options Annex conducted its own test using a Put Debit Spread and compared the results with the Long Put. We used the same Long strike for the spread so that the POP (probability of profit) remained unchanged; and we used 5-spreads (rather than one) to closely match the capital at risk of the Long Put of $1,955.
The Put Debit Spread we tested was the June 830/820 on May 20th, for a cost of $2,025 (option price $4.05 x 5 x 100); or a difference of $70 between the Long Put and 5 Put Debit Spreads.
The results? While the Long Put lost $920 (or a -47% ROC), the Put Debit Spread gained $275 (or a 13.6% ROC). This is difference of $1,195 (-920 - 275), which is quite significant.
Let's see why this occurred. Remember, the two factors affecting an option's price is theta and vega, and any strategy (like a spread) that reduces their impact (especially theta) would be helpful. Looking at the Table above, we see the following: for the Long Put, theta was -0.37 on May 20th, and increased to -0.74 by June 17th, while vega was 0.98 and 0.38 respectively. For the Put Debit Spread, theta was -0.02 on the 20th and 0.02 on the 17th (now positive since the spread is ITM), while vega was 0.05 and 0.01 respectively.
As you can see, the two factors are much smaller for the spread, and therefore have less of an impact on the price of the spread over time. Also noteworthy is that theta went positive for the spread (meaning as time passes, the spread will gain value), due to the difference in theta between the two options; it would require the Long position to be much further ITM just for theta to reach zero (it will never go positive).
In conclusion, at the same level of POP and capital at risk, the Put Debit Spread offers a better ROC than a Long Put by reducing the impact of both theta and vega. Next time you want to consider a directional play, consider the Debit Spread over the Long (whether Put or Call).
If you would like to learn more about options, and how to easily generate consistent weekly income trading options, go to Options Annex.