Q&A
Explore Your Options
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.
Debit and Credit
What’s the difference between a debit spread and a credit spread?
When investors buy or sell options, the transaction is either a debit or a credit. Of course, since an option contract is an agreement between two parties, each trade is for a debit to one party, but a credit to the other. Nevertheless, if I buy October 800 puts on the Standard & Poor’s 500 (Spx) for $3.50 per contract, I pay $3.50 per contract and that amount is a debit to my brokerage account. If Spx falls below 800 and I then sell the put for $10, I receive a credit in my account.
The same principle applies to a spread. If I buy the Spx October 800 put for $3.50 and sell the Spx October 770 put for $1.00, I pay a net debit of $2.50 (or 3.50 - 1.00). I have entered a debit spread because one side of the spread costs more than the other. On the other hand, if I initiate a new position by selling the October 850 put for $10 and buying the October 800 put for $3.50, I receive a net credit of $6.50 (or 10 - 3.50). I have entered a credit spread.
Bull Put Position Adjustment
If my bull put spread starts going against me and the stock has fallen below the strike price of the long put (the one I purchased), what are my options to recover some of my losses? Do I just take the loss or can I somehow minimize my losses in a bull put spread if the stock moves downward?
The bull put spread is a type of credit spread. The position involves selling a put and buying a put with a lower strike price as a hedge. Like the straight selling of puts, the investor has a bullish view on the stock when the position is initiated.
Sometimes investors will sell puts on stocks they want to own. For example, if I am a willing buyer of Wells Fargo (Wfc) at $20 per share and the stock is trading for $23, I might sell an October put at the $20 strike for $2 per contract. If it doesn’t fall to that level by the October expiration, no problem, I keep the $2 credit. On the other hand, if it falls below $20, I will get assigned and buy (have put) the stock to me at $20 (100 shares for every short put).
The risk of naked put selling is that the stock makes a substantial move lower. If Wfc falls to $10 per share and I am assigned at $20, I have a $10 paper loss on the stock. I received $2 premium for the put sale, so my net loss is $8. So I collected $2 and my loss is $8 — not a great risk-reward scenario.
In order to hedge the risk of naked put selling, I might also buy a put with a lower strike price. For example, instead of straight selling the Wfc October 20 put for $2, I also buy the October 15 put for 50 cents. My net credit is $1.50 ($2 - 0.50) and my risk is now limited by the strike price of the put that I own, or $15.00. If it falls to $15 or less, I can exercise my put to offset the assignment of the October $20 put. My loss is now $5.00 minus the credit received, or $3.50.
Whether selling straight puts or trading bull put spreads, the investor wants the stock to stay above the strike price of the short put. If the stock is trading between the two strike prices, the trade is not working out as planned and there are a few possible adjustments: 1) Do nothing and await assignment, which will result in owning the stock. The long put will expire worthless; 2) Do nothing, cross your fingers, and hope the stock bounces (generally not recommended); 3) Close the position entirely and take the loss; 4) Roll the position to a later expiration month and a lower strike price; and 5) Close out one side of the trade.
Most important, closing out the long side of the spread and hoping the stock moves higher will defeat the purpose of buying the put in the first place — that is, it will leave you holding a naked short put. On the other hand, closing out the short side will leave you holding only a long put, which goes against the bullish view of the stock. In conclusion, if you don’t want to face assignment and own the stock, the best option might be to close out the trade altogether and move on to a better opportunity.
Sizing Up Skews
What is responsible for the expansion and contraction of volatility skew between strike prices? Is it mostly supply & demand, and that keeps things from being more linear?
Skews happen for different reasons, but when a big one develops, it is normally because of strong demand in a specific option contract. Remember that each option contract has a unique level of implied volatility that is always changing. A skew develops when two option contracts on the same stock, index, or futures have substantially different levels of implied volatility.
Several factors will determine the implied volatility of the contract, including the volatility of the underlying asset. That’s why most options on the same stock will have similar implied volatility. However, since the option market is efficient in pricing in future volatility, a skew can develop ahead of an important event. Say it’s early July and Ibm is due to report earnings on July 10 before the July expiration. It is likely that the July options will have higher implied volatility compared to August because the prices will reflect the possibility that the stock will see a big move around the earnings report. In other words, there is a skew between the July and August options.