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Option Spreads - Advantages of Debit and Credit Spreads

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Most traders treat options in a manner similar to equities and futures: long or short directional trades.

So, it is not surprising that a large percentage of option trades are not spread trades.

If option spreads (vertical or horizontal) offer significant advantages, then why aren't there more spread trades? Well, my response is this: first, it is a matter of education. Most traders do not fully understand how options work, so they are more comfortable trading options like other instruments (equities, futures, etc.). As option education reaches more traders, so will the percentage of spread trades.

And second, the transaction cost for trading spreads is at least twice that of trading options long or short (the simpler alternative). This is because the spread is composed of two (or more) options vs. one option for the simpler alternative.

Let's look more closely at spreads, and their advantages.

LONG VS. VERTICAL DEBIT SPREAD
This can be best shown by example. We will compare a long Call position against a $1 wide and $2 wide vertical Call debit spreads.

At the close on 7/5/13, we compare three directional trades: a long Call JUL13 165, a Call JUL13 165/166 debit spread, and a Call JUL13 165/167 debit spread.

SEE CHART ABOVE

Lower Risk
Despite the fact that transaction costs are higher, the cost of the position can be considerably lower (depending on the width of the spread).

From the above, we can see the that the cost for the Long position is 135% greater than the cost of the $1 wide debit spread and over 42% greater than the $2 wide debit spread.

First, this means you are risking more capital on the Long position than either debit spread. As a result, if the trade is not successful (probability of expiring OTM, or worthless, is approximately 70%), you will lose $74 on the long position (vs. $31.50 and $52 respectively).

And second, the cost savings for both debit spreads far exceeds the additional transaction cost.

Now to be fair, the lower risk comes at a cost: a cap on the max potential profit. What makes the long Call so attractive is that max profit is unlimited; but this doesn't change the probability of failure (around 70%). As expected, the more you risk, the greater the potential reward.

Higher Probability of Profit (POP)
Both debit spreads have a higher POP than the long Call. This is because the breakeven points of both debit spreads are lower: 165.32 and 165.52 respectively vs. 165.74.

While this might not seem like much, remember that a contract represents 100 shares, so we are dealing with the long Call having to overcome its high initial cost of $74 before it becomes profitable.

Lower Impact of Theta and Vega
The two market conditions that can make or break a long position is time (theta) and volatility (Vega). When you have a long position, you need to be right not only about direction, but also how quickly the underlying will move in your direction, and that volatility will not collapse. That is, you need to be right about three conditions; not one.

The two spreads above considerably reduce the impact of both theta and Vega; thus removing two of the three conditions you need to be absolutely right about.

The long Call position has a theta value of -4.49. This means that the value of your position will lose $4.49 the next day. If you are within 30 days of expiration, you will likely see this figure increase significantly as you get closer to expiration. The theta for the two debit spreads are -1.0 and -2.06 respectively; or less than 1/4 and 1/2 the size of the long Call. This is a huge difference, and helps you keep your position on longer with less time decay impact.

Of even greater importance is the dramatic reduction in Vega. For the long call, the Vega is 11.62; that is, for each percentage point drop in volatility, the long Call position will lose $11.62.

Compare this to Vegas of 2.08 and 4.65 respectively; that is just 18% and 40% of the size of the long Call. This means that the two debit spreads will weather declining volatilities better than the long Call.

With regard to long Put positions vs. vertical Put debit spreads, the outcome is the same with theta and Vega having the same sign. You have a slightly better chance with Vega since declines in the underlying are generally accompanied by increases in Vega.

SHORT VS. VERTICAL CREDIT SPREAD
What about short positions vs. vertical credit spreads? The only time you would want to do a short (or naked) position is with a low cost underlying (under $50) because the capital at risk would be too high. The short position brings in enough premium to attract traders, while credit spreads do not.

Generally speaking, a low cost underlying will have lower liquidity and less strikes per chain, which just adds to the risk. Imo, you would do better with credit spreads on high cost underlyings that have far more liquidity and strikes within the chain.

The big advantage of OTM credit spreads is that you can dramatically improve your POP well into the 90% range, and become non-directional (for the most part).

Let's take a look at the SPX index options (a very high value underlying) in which there is considerable shorting by those with very large accounts. We will use the same end-of-day data as the previous example, 7/5/13, the same monthly, JUL13, and the same approximate probability of expiring ITM, 30%.

SEE CHART ABOVE

What are the advantages of the credit spreads?

Lower Risk
The capital at risk with the short Call position is $5,275 (using a theoretical 2 std. dev. further OTM long strike). With many brokers, the actual margin requirement will be the max possible loss of $165k.

This compares with $325 and $690 for the credit spreads, respectively. Using the conservative figure of $5,275, the credit spreads are risking just 6% and 13% of the capital at risk with the short position. That is quite a substantial reduction in risk.

Better Return on Capital (ROC)
ROC is measured by the max profit divided by the capital at risk. For the short Call position, the ROC is 13.74% (725 / 5,275); for the credit spreads, the ROCs are 54% (175 / 325) and 45% (310 / 690), respectively.

Given these high ROCs, you would only need to place 2-4x the number of spread positions for each short Call position to obtain the same premium, but still at considerably lower capital at risk.

Lower Impact of Vega
Vega is negative for all positions, indicating that a decline in volatility will improve position value. Conversely, any increase in volatility will compromise the position. Just as with the comparison of the vertical debit spreads, the credit spreads have considerably reduced exposure to volatility. The short Call position has a Vega of -113.42, vs. -9.46 (8.3%) and -20.39 (18%) for the credit spreads, respectively.

Since these are short Call positions, they favor the underlying declining in value, which generally increases volatility. Having a significantly lower sensitivity to volatility is a big plus.

In conclusion, vertical spreads (both debit and credit) offer advantages that far overcome the increased transaction cost and reduced profit. In fact, for credit spreads you can obtain higher premium at considerably lower capital at risk by just increasing the number of contracts (or spreads).

If you would like to learn more about options, and how to generate consistent weekly income trading options, go to Options Annex.

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