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. Contributing analysis is by senior Optionetics strategist Chris Tyler.
MAKING BETTER “CENTS” OF A SALE
Is selling an at-the-money (Atm) or out-of-the-money (Otm) option really better than selling a contract that has more premium attached to its market price due to its intrinsic worth?
That’s a tricky one. As for which type of sale constitutes the “better” one, we do know selling extrinsic or time premium associated with Atm or Otm has the advantage of time decay. All options do lose 100% of their extrinsic value by expiration. However, whether a contract lands in or out of the money and by what amount can prove to be the more important factor in calculating actual profits and losses.
At the end of the day, it does a trader little good if they’ve sold an Atm contract for, say, $1.25 with 100% extrinsic value if it loses all that value but is worth $10 intrinsically come expiration. Bottom line, if the trader failed to hedge the contract’s delta risk as the rise in shares created real value for either the short call or short put, he or she would be out $8.75.
It’s critical for traders to ask what they’re trying to accomplish with their overall positions.There is also the double-edged sword of implied volatility risk. If premiums begin to rise due to higher implieds rather than movement in the underlying, the trader’s short extrinsic value will be exposed to greater paper losses than someone positioned short in a deeper contract with less vega or volatility risk per point shift in that factor.
Finally, it’s also critical for traders to ask what they’re trying to accomplish with their overall position. Is the sold contract supposed to act as a delta hedge and the equivalent of shorting or buying of shares? If so, the deeper call or put contract could be seen as the more appropriate sale. Is the sale looking to take advantage of a spike in implieds determined as a temporary and opportunistic situation? Does the trader wish to collect decay in a sideways market? If you answered “Yes” to the last two questions, then the Atm or Otm contracts become the more likely targets for shorting opportunities.
A DEBIT TO THAT CREDIT
I’ve been told that selling credit spreads is a smarter way to position than debit spreads. Is this true for both directional and nondirectional positions?
It sounds like what you’re hearing is mixed information and not wholly factual at that. Let’s start by saying if there were some consistent edge in credit spreads versus debit spreads, market participants would quickly and efficiently exploit it to the point of that advantage being priced out of the market. That’s just common sense.
As an option trader, you must realize that credit spreads can be designed with synthetic debit equivalents and vice versa — and thus confirming our first argument.
For instance, a bull put vertical credit spread and a bull call debit spread executed on the same strikes in the same calendar month are one and the same if we make the basic assumption of equivalent and strong liquidity provision in both option types (calls and puts) and assume no dividend ex-dates during the cycle.
To confirm this, let’s look at the ultra-liquid iShares Silver Trust exchange traded fund (Slv) on July 12. With shares at $35.20, the August 35/36 bull put spread could be sold midmarket at $0.54 with the strikes of both individual options a penny wide between the bid and ask price. If 10 spreads were executed, the trader would take in a credit of $540 while maintaining risk of $0.46 or $460 at expiration if Slv closed below the purchased 35 strike.
At the same time and reflective of the influence involved with arbitrage available through synthetic equivalent markets, the August 35/36 bull call spread was priced for a debit of $0.45. The cost for 10 spreads puts the trader at risk for $450 if Slv is below 35 at expiration but allows for profits of $550, or $0.55 per spread above 36.
In this case, the penny advantage goes to the call debit spread and not the put credit spread. Truthfully, though, while this debunks some of the myth of credit versus debit spreads, the amount isn’t exploitable and really just stresses the efficiency of markets. Despite the incredible liquidity provision, we can’t say a trader could buy the call spread and offset that risk by establishing a bear put vertical to form a box (arbitrage) and therein guarantee themselves a penny profit, but before the negative impact of factoring in commissions.
But what about the initial credit and collecting interest on that money? This is also a bit of an industry white lie, and goes hand in hand with the efficiency of markets described above. Yes, a trader will receive a credit for a spread such as a bull put vertical or, for that matter, a nondirectional spread like an iron condor. But that credit is only received after your broker reduces your trading account value by the maximum risk of the spread without considering the initial transaction amount. This process involves two steps but leads to the same result as if one had positioned using the equivalent debit spread.
Looking once again at our Slv illustration, the trader executing the bull put spread would first have $1,000 removed from their account (one point vertical x 10 spreads) due to the assessed risk. Then, as a second step, the credit of $0.46, or $460, is returned to the account.
What does this come down to? This means the broker has provisioned for the maximum loss and you don’t really collect the credit, as $540 has been removed. As much, the credit spread and its impact on your account will look identical to the bull call debit spread purchased for $0.45. Though with that spread having the slightest of nominal advantages as we showed before, I guess you could say that’s a penny for your thoughts on the value of credit spreads.
Contributing analysis by senior Optionetics strategist Chris Tyler