Q&A
Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the Stocks & Commodities website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. Contributing analysis is by senior Optionetics strategist Chris Tyler.
MARRIED TO A CALENDAR?
I’ve read about getting into married put and collar positions using short puts. I also realize you can cut down risk if assigned by selling a bull put spread instead. What about using a long put calendar to enter into a married put?
Using a long put calendar or time spread can certainly allow a trader to establish a married put if the front short contract is assigned; however, there can at times be advantages to approaching a married put with this strategy. As with the bull put spread, not only are you in a limited risk position, but upon assignment the married put is in place as the long stock is already hedged with the back-month put.
Conversely, the holder of a vertical that receives assignment on the put may need or want to go back into the option market to redesign his or her married put, as they don’t have a longer-dated contract to guard the new long stock holdings. This trader only maintains protection into expiration which, if exercised, will result in a closing of shares for a loss equivalent to the strike distance of the vertical minus the initial credit.
Unlike with a vertical, a time spread can enjoy larger than expected returns if implied volatility and time decay work favorably during the holding period — for instance, if shares sit into expiration at the purchased calendar strike and implieds rise during this period. Ultimately, intermonth relationships aren’t fixed as they are for a vertical which, once transacted, has a defined profit and loss.
On the other hand, if the time spread is on the wrong side of implied volatility, potential profits could be a good deal smaller than anticipated. This is due to the spread being long back-month vega, which isn’t guaranteed to move in sync with the front short contract. That said, our maximum loss is secure and not prone to increasing in size or being a good deal larger than expected, as could be the case with a short put or what some refer to as a targeted purchase.
Another caveat regarding the long put calendar as a starter position for a married put or collar is if the stock goes up. Unlike with the more widely used short put or bull put spread, which would profit if the underlying is anywhere above the higher shorted strike, a bullish move away from the time spread’s positioned strike is going to result in a spread that’s worth less money. As this spread feature is less aligned with the married put or collar, both of which are bullish strategies, this poses an additional challenge for strategists interested in using the long put calendar in this capacity.
DISCOUNT TO PARITY OR NOT?
Why do some in-the-money (ITM) verticals such as the bull call spread trade at less than parity before expiration? Intuitively, with its protective value, isn’t this a better deal than holding long stock if bullish on the underlying, or am I missing something?
Limited risk is a nice feature of bull call spreads, or all verticals, for that matter. It’s also a double-edged sword that helps explain the greater relative worth of certain ITM bull call spreads at expiration, versus when time is still on the clock.
Ask yourself: Would you be willing to pay parity for a bull call spread prior to expiration? Let’s say shares of XYZ are stationed at 66 and there are two weeks left for the July contract. Would the 60/65 call vertical be enticing for $5.00 per spread? How about if shares were at 70 or even 75? If you answered “If I were a seller,” you’re halfway to understanding your own question.
In each instance and the spread maxed out as far as profit potential goes, there is no incentive for a buyer to purchase the vertical as there’s only risk of $5 per spread. But what about an ITM spread where shares are still trading between the strikes? That depends on where the underlying is in relation to the vertical.
A rule is when the underlying is trading above the midpoint of the bull call spread, the pricing will reflect a situation of “less than parity” like you described. This is due to the important relationship of extrinsic or time value potential in both options, which brings us back to the double-edged sword aspect of verticals.
Using the 60/65 call vertical again, let’s say XYZ is at 64 and firmly beyond the midpoint of 62.5. Again, what would you pay? If you said more than $4.00 or its expiration parity value, you’re not appreciating the fact that the short contract, while holding no intrinsic value, will maintain more extrinsic value than the ITM 60 strike call if implieds allow for the presence of time premium. In fact, the lower strike call may trade for parity if implieds are low enough so the 60 strike put is effectively offered with no bid. So if the deep call trades for $4.00 or parity and the 65 call is fetching $0.40 in the open market, the spread’s fair or market value is $3.60.
This spread value reflects the benefit of having sold time premium and thus giving the bull call spread the illusion of a discount to the share price of 64. At expiration and all else being equal, the vertical will expand to $4.00 as the 60 call is still worth $4.00, but the short contract will be worthless, netting the bull call trader $0.40 per spread.
The downside of this below-parity bargain is, as emphasized here, unlike a long call position or long stock, the profit potential of a vertical is capped. The closer to this dollar figure we pay, the less that can be made and the more that’s at risk.