November 12th, 2012:
Sell to Open DEC 600 put @-$11.10
Buy to Open DEC 595 put @$10.20
Initial net credit = -$ 0.90
Maximum risk / margin req. = $ 4.10
Percent maximum return = 22% ($0.90 max. gain / $4.10 requirement)
The prices listed were the natural bid price for the short option (DEC 600 put) and the natural ask price for the long option (DEC 595 put) when the trade was analyzed. When we enter any vertical spread, or any options position, we will calculate the net credit / debit using the mid-point pricing as well as compare the initial position to its parity trade.
Using the mid-point pricing as a limit net credit (or net debit) order can increase the potential return of the spread position. In general, getting filled at the mid-point prices is not uncommon provided that the options you are trading have a relatively high liquidity (option volume and open interest) and that the bid-ask spread is not too wide to begin with.
Using the Mid-Point Spread Chain tool on PowerOptions later in the day on November 12th, we saw the potential for an additional gain if the mid-point pricing was used for the PCLN spread:
The natural bid and ask prices were different from the original bull put credit spread, but let's look at the comparison using the numbers from the image above:
PCLN bull put spread natural:
Sell to open DEC 600 put @-$11.40
Buy to open DEC 595 put @$10.40
Net credit = -$ 1.00
Maximum Risk =$ 4.00
Percent max. return = 25%
PCLN bull put spread mid-point pricing:
Sell to open DEC 600 put @ -$11.50
Buy to open DEC 595 put @ $10.25
Net credit = -$ 1.25
Maximum risk = $ 3.75
Percent max. return = 33.3%
If we are able to get filled at the mid-point prices we can increase the net credit, lower the monetary at risk and increase the potential percent return by 8% over the natural spread prices. This is fairly common knowledge but it always helps to reinforce the basics to help maximize returns.
Every options position has a parity trade. A parity trade is a position using different options to create a similar risk-reward profile. The parity trade to a bull put credit spread is the bull call debit spread. In a bull put credit spread we will sell an out-of-the-money put and buy a deeper out-of-the-money put. A credit is received when the spread is filled. The maximum risk is equal to the differences in the strike prices minus the net credit. The maximum profit is realized when the stock is trading above the short put strike price ($600) and the maximum loss occurs if the stock is trading below the long put strike price ($595).
A bull call debit spread using the same strike prices would offer a similar risk-reward profile. A bull call debit spread consists of selling a call option with a strike below the current stock price (in-the-money) and buying a call option at a lower strike price (deeper in-the-money). The spread is entered at a net debit as the deeper in-the-money long call will have a higher premium than the sold call. Whenever one enters into an options trade or spread position, we must understand the obligations and rights of the position.
Selling a call option: Investor may be obligated to deliver shares of stock at the call strike price if the stock is trading above the strike price at or before expiration. Selling a call option without being covered by stock or a long call will have infinite risk (naked call).
Buying a call option: Investor has the right, but not the obligation, to buy shares of stock if the underlying is trading above the call strike price at or before expiration.
If we sold a DEC 600 call and bought a DEC 595 call the maximum profit would be realized if the stock was trading above $600.00 per share at expiration. The maximum loss would occur if the stock was below $595.00 at expiration. Instead of receiving a net credit for opening the spread, the investor would pay a net debit. The net debit is the maximum risk for the position and the maximum gain is defined as the difference in strike prices minus the net debit. Here is the parity bull call debit spread for PCLN:
The static profit and loss chart is almost identical to the bull put spread, but here we see a slight advantage for pricing and return. Using the mid-point pricing we could potentially enter the bull call spread for a debit of $3.60. If PCLN stays above $600.00 at expiration we could exercise the long call to buy shares at $595.00 to fill the obligation for the $600.00 strike call option. We would receive $5.00 at expiration resulting in an overall profit of $1.40 per contract (38.9% return). If PCLN falls below $595.00 at expiration both calls would expire worthless and we would lose the initial net debit of $3.60 per contract.
Here is a basic break-down of the parity bull spreads for PCLN:
Max Profit occurs @
Max Loss occurs @
% Probability Above*
Mid-Point Max. Return
Mid-Point Max. Loss
$1.25 / cont.
$1.40 / cont.
In the chart above we mention the percent probability above. At the time the trades were analyzed, this number represents the theoretical probability that PCLN would be trading above $600.00 at December expiration. This is one of the columns that is shown in the parity view of the Mid-Point Spread Chain tool:
To identify the potential trades we simply enter our stock symbol (NASDAQ:PCLN) and some basic information such as: % Return greater than 25%, % probability greater than 70% and maximum monetary profit greater than $1.00. Since both bull spreads realize the maximum return if the stock is trading above $600.00 per share, they both have the same theoretical probability of success.
The numbers on this screen shot are slightly different than the examples used but it still shows us that in some cases the parity trade may yield a higher return. What we can also see from the parity view above is that not every parity trade will result in a higher return. If we wanted to be more conservative we may have selected the 595 - 590 strike bull put or bull call spread. Notice that the put spread return would be 33.3% and the parity trade bull call spread would offer a potential 31.6% return. For that strike selection the bull put credit spread may be the better alternative.
Many vertical spread investors prefer to use credit spreads as the premium is available in their account once the trade has been placed. The investor may then be able to use those proceeds to purchase other options or to use in other strategies. However, before entering any vertical spread an investor should evaluate the parity trade to see if there is a potential for a better yield if the stock performs as expected. As we all know, stocks sometimes do not perform as expected and the position may need to be managed to minimize losses. In our next article we will discuss some basic vertical spread management techniques with an eye to the advantages and disadvantages of managing a bull put credit or bull call debit spread.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.