Tuesday, December 15, 2009

Mail Time- Call vs. Put Spreads

When do you use a bull call spread vs. a bull put spread?

Before I divulge my personal preference, let's review the difference between the two. The bull call spread (sometimes referred to buying a call spread) involves simultaneously buying a lower strike call and selling a higher strike call option of the same expiration month. The bull put spread (sometimes referred to selling a put spread) involves simultaneously buying a lower strike put and selling a higher strike put option of the same expiration month. They both realize max profit if the stock resides above the higher strike price at expiration. We consider them equivalent or synthetic positions. In other words, the risk-reward characteristics should be virtually identical. Let's use the Russell 2000 index(RUT) to illustrate. With the RUT currently trading at 611, suppose we were considering entering either an in-the-money January 560-550 bull call spread or an out-of-the-money 560-550 bull put spread (click to enlarge).

[Source: EduTrader]
As you can see the risk graphs are virtually identical. Either the call spread can be bought for $9.00 debit or the put spread can be sold for $1.00 credit. I used the mid point of the bid and ask for each option.

Though they are identical on paper, the reality is most traders would prefer to trade the put spread in this scenario. Why? In my opinion the primary reason is the liquidity of out-of-the money puts versus in-the-money calls. Consider the open interest of the Jan 550 calls vs. puts: 302 vs. 11,472. A comparison akin to having Mini-me stand next to Shawn Bradley. The puts absolutely dwarf the calls (no pun intended). We can ascribe the drastic difference to the fact that you've got a lot more market participants interested in out of the money puts versus deep in the money calls. The open interest has a direct influence into the bid-ask spread. Currently the 550 calls are 64.40 by 65.60. The puts, on the other hand, are $3.50 by $3.70. Which would you rather try to navigate- the $.20 or $1.20 spread?

The other two issues often cited have to do with shorting in-the-money options vs. out-of-the money options. I'd venture to say most traders prefer trading out-of-the money options for two reasons: avoiding any early assignment issues and saving commission by allowing the option to expire worthless. I almost always close positions prior to expiration, so not sure the avoidance of commission applies for me. In addition, being assigned early on an in-the-money call spread results in realizing the max profit, so not sure that's necessarily a bad thing.

When using strike prices below the current price, I usually opt for using a put spread. On the other hand, when using strike prices above the current price, I usually opt for using a call spread.

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