A 'Hidden Reality' Of Vertical Options Spreads

Includes: NFLX
by: Richard Bloch

Some comments in my article on “the poor misunderstood VIX” were discussing the best books and web sites on options.

One of those comments, by “biovirus,” suggested Options Trading: The Hidden Reality by Charles M. Cottle as being one of the best, but that it was written in ”a Gurdjieffesque way.”

I confess that I don’t know exactly what “Gurdjieffesque” means, but I’ve read the book, and it’s certainly esoteric. It’s very difficult to get through, but the way the author presents options concepts might be valuable to some.

Here’s one of the “hidden realities” It’s not really all that hidden, just another way of viewing vertical spreads. I’ll present the concept in terms of a Netflix (NASDAQ:NFLX) trade that I don’t recommend, but am using simply as an example.

Bullish On Netflix? Perhaps Buy A 90/100 Call Spread

On November 1, Netflix closed at 80.09. Let’s say you think the stock is going to go up to perhaps $100 by mid-December. As of the close, you could have purchased the December 90 call and sold the December 100 call for a net debit of $222.

There are 10 points between the strikes, so the most this out-of-the-money call spread could be worth is $1,000 - or a maximum net profit of $788. That’s essentially a “risk 2 to make 7” scenario.

... Or Sell The 70/60 Put Spread Instead?

Maybe I’m bullish on NFLX, too, but I decide to sell an equivalent put spread. I might sell the December 70 put and buy the December 60 put for a net credit of $216.

Because I’m collecting the credit, that’s the maximum profit. But there are 10 points between the strikes, so I could end up having to cough up $1,000 to close the spread – or a net loss of $784.

So I’ve set up a “risk 7 to make 2” scenario. That sounds pretty crummy, but let’s take a look at the characteristics of these two spreads.

These charts show the net profit of these two spreads at various times until expiration.

One thing to note is that the call spread loses money over time unless the stock rises to above 95 or so. Otherwise, negative theta brings the value of the spread down.

The put spread, however, gains in value if the stock stays above 70 or so. As long as the price stays above that level, this spread has positive theta.

Also notice that this spread could conceivably be closed as a net loss of perhaps $220 or so even if the stock falls near expiration.

No guarantees, of course, but if you assume you could act quickly enough, that “risk 7 to make 2” scenario could be viewed as roughly “risk 1 to make 1.”

(I will point out, however, that I’d certainly have to pay an extra commission to close my put spread, but the call spread could simply expire worthless.)

Where Does The Money Go?

Let’s say the stock does absolutely nothing. Highly unlikely in the case of Netflix, but let’s make that assumption for the time being.

Here’s what these two spreads would look like over time if the stock went nowhere.

Note that the call spread losses to time decay roughly corresponds to the money made from time decay in the put spread. The book's author Charles Cottle would say that the premium from one spread essentially gets poured into the other opposite spread.

Now envision every possible vertical spread in the option chain with negative theta as having an equivalent, yet opposite vertical spread that has positive theta.

Is this a “hidden reality”? Not really. The options and their prices are there in plain sight. But the way Cottle presented it did give me one of those “aha” moments when I first got the book.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.