In my first article about options myths and misconceptions, I presented several common myths about options trading. I showed how you can use options in a different way than just buying calls or puts and still generate very significant gains. I also showed how many smaller winners with lower risk might be better than few larger winners with higher risk and it is not necessary to aim for 100% gain in each trade to be profitable.
In my second article, I wrote about the risk/reward of the non-directional trading. I showed how you can use the same strategy (Iron Condor) with different profit potential, ranging from as low as 23% and as high as 400%. So when I see a comment like "I despise Iron Condors. May as well trade bonds for the ROI those things provide.", I'm wondering how ignorant some people can be about options trading.
In this article, I would like to expose another common misconception about credit spreads vs. debit spreads.
Misconception:
"One of the many drawbacks of a credit spread is that it will tie up so much capital."
The simple truth is that credit and debit spreads require exactly the same capital. You just have to compare apples to apples. You cannot compare a credit Iron Condor with a debit Butterfly or debit calendar spread. Doing this shows a complete lack of understanding of different options strategies. The comparison should be done based on the same strategies and same strikes.
I will do the comparison based on the closing prices of Apple (AAPL) options on March 9, 2012. Below you can find the options chain of the March options.
Lets start with the simplest trade - a Vertical Spread. Take a look at the following two trades:
Trade #1A:
- Buy AAPL March 2012 530 put
- Sell AAPL March 2012 535 put
Trade #1B:
- Buy AAPL March 2012 530 call
- Sell AAPL March 2012 535 call
Both trades are bullish - the maximum gain is realized if the stock is above $535 by March expiration. If the stock is below $530, both trades will experience the maximum loss.
This is the P/L graph of the trade:
In the first trade, you get a $103 credit. The margin requirement is $397 which is the difference between the strikes less the credit received. If the stock is above $535, both options expire worthless and you keep the whole credit. The maximum gain is 26% (103/397).
In the second trade, you pay a $403 debit. The maximum gain is realized when the stock is above $535, in which case the spread will be worth $500. The maximum gain is 24% (500/403).
You might notice that the maximum gain of the second trade is slightly lower than the first trade. This is due to the fact that in the second trade we used ITM (In The Money) options which tend to be slightly less liquid than the OTM (Out Of The Money) options. However, the capital requirements and P/L profiles of both trades are very similar, almost identical. In fact, the capital requirement of the credit spread is slightly lower - again, due to higher liquidity of the OTM options.
Lets move now to the next level - an Iron Condor. The Iron Condor is a combination of a bull put spread and a bear call spread. The whole trade is done for a credit.
Lets examine the following trade:
Trade #2A:
- Buy AAPL March 2012 530 put
- Sell AAPL March 2012 535 put
- Sell AAPL March 2012 555 call
- Buy AAPL March 2012 560 call
You get a $215 credit. The margin requirement is $285 which is the difference between the strikes less the credit received. If the stock is between $535 and $555, all options expire worthless and you keep the whole credit. The maximum gain is 75% (215/285).
This is the P/L graph of the trade:
The same trade can be done with calls only or with puts only:
Trade #2B:
- Buy AAPL March 2012 530 call
- Sell AAPL March 2012 535 call
- Sell AAPL March 2012 555 call
- Buy AAPL March 2012 560 call
You pay a $291 debit. If the stock is between $535 and $555, the trade is worth $500.The maximum gain is 72% (500/291).
Trade #2C:
- Buy AAPL March 2012 530 put
- Sell AAPL March 2012 535 put
- Sell AAPL March 2012 555 put
- Buy AAPL March 2012 560 put
You pay a $282 debit. If the stock is between $535 and $555, the trade is worth $500.The maximum gain is 77% (500/282).
In all three trades, the P/L profile is exactly the same. The capital requirements are slightly different - again, due to slightly different pricing of OTM and ITM options, but all of them are around $285-290.
To avoid any confusion or nasty comments, please note that those are just examples, not trade recommendations.
Same analysis can be done for the butterfly spread or any other strategy. The important thing is comparing apples to apples i.e. the same strategy with the same strikes. Comparing Iron Condor to a butterfly or a calendar spread is completely meaningless. It's not a credit or a debit that matters, it's the strategy and the strikes.
Next time someone tries to convince you that "credit spread ties up so much capital", do your homework and check the hard facts. There are many "experts" out there who can be very misleading.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
