At a Crossroads
by C. Talmadge BellJuly 26, 2012 | Comments : 0 Recommended this article: (0)
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In recent articles I have discussed both the Bull Call Spread and the Bull Put spread. These are both a type of option strategy that is used when the outlook for a stock is neutral to moderately bullish. That would be in a market very much like we are experiencing at this time. We find very few trends and plenty of setups that look like only a short term trade.
Since both strategies will work well in a neutral to slightly bullish market, it is often a dilemma to decide which of the two to use. In this article, I'll compare the two approaches and give you some examples of how each would affect a specific trade. This will give you a good foundation for deciding which strategy you would use in your trading.
A review of the Bull Call Spread and the Bull Put Spread
The Bull Call Spread is created by buying a Call that is usually slightly in-the-money or at-the-money and also selling a Call that is at a higher strike price (usually out-of-the-money) than the strike price of the first Call. This type of trade has a defined loss of the amount of the premium paid for the trade. It also has a defined gain that will be the amount derived by subtracting the lower strike price from the higher strike price and then subtracting the net amount of the premium paid from that number. This is a debit trade.
The Bull Put Spread is created by selling a Put that is usually slightly in-the money or at-the-money and also buying a Put that is at a lower strike price (usually out-of-the-money) than the strike price of the first Put. The trade has a defined loss that is calculated by subtracting the lower strike price from the higher strike price and then subtracting the net amount of the premium received from that number. It also has a defined gain thats simply the net amount of the premium that is received at the time the trade is placed. This is a credit trade.
How are the Bull Call Spread and the Bull Put Spread similar?
1) Both strategies involve buying and selling an option of the same type and with the same expiration date.
2) The maximum loss for both strategies is predefined at the time that the trade is placed.
3) The maximum gain for both strategies is predefined at the time that the trade is placed.
4) Both strategies profit if the stock price moves up.
5) Both strategies have the same shape of the P/L curve.
6) The amount of the gain and loss is predetermined by the trader in the way that the strike prices are placed.
How are the Bull Call Spread and the Bull Put Spread different?
1) The Bull Call Spread is a debit trade, but the Bull Put Spread will be a credit trade (you receive money at the initiation of the trade).
2) The margin requirements will be different (but very similar).
3) The Bull Call Spread will have a higher maximum profit and a lower maximum loss.
4) The Bull Put Spread will have a more favorable breakeven point.
5) The Bull Put Spread is considered short volatility and may make a profit even if the underlying stock has little or no movement at all.
After looking at the similarities and the differences, how do you decide which one to use? Let's look at actual examples of a trade where you can compare the potential results and the risks involved in each strategy. In the following setups that underlying instrument is the SPY. At the time that the calculations were made, the SPY was trading at $135.11.
Which is the Best?
Perhaps the first thing that you notice is that the Loss and the Gain for the Bull Call Spread appear to be much more attractive. For the Bull Call Spread the Maximum Loss is $1.03 vs. $1.35 for the Bull Put Spread. The Bull Call Spread has a potential Gain of $0.97 vs. $0.65 for the Bull Put Spread. So, initially, it might seem that the choice is obvious. The Bull Call Spread has a higher potential gain and a lower maximum loss.
However, there is another way to look at the two strategies. To see this other perspective, compare the breakeven points. With the Bull Call Spread, the breakeven is at $136.03 vs. $134.35 for the Bull Put Spread. What does this mean?
Well, with the Bull Call Spread, the price of the SPY will have to move up $0.92 to $136.03 before the trade can begin to make any profit at all. The price of the SPY will have to continue to move up to the higher strike price of $137 or higher for the maximum gain to be realized.
But, for the Bull Put Spread, the price of the SPY doesn't have to move up at all for the trade to have a gain. The maximum gain will be realized if the stock is at the higher strike price of $135 at the time of expiration. This trade will have some gain even if the price of the SPY drops. The position will go into a loss only if the price of the SPY falls more than $0.65 to $134.35.
You can see that the decision regarding which is best comes down to your own personal risk tolerances. If you are an aggressive trader and have a more bullish expectation for the movement of the underlying instrument, you will feel that the Bull Call Spread has a greater profit potential.
If you have a more conservative perspective on the underlying instrument and are only slightly bullish, the Bull Put Spread may be the way to go. You will probably feel that the Bull Put Spread's potential to realize a profit (albeit smaller than the Bull Call Spread) whether or not the underlying instruments price moves or not.
Finally, to add a bit more variety to your choices, keep in mind that you can vary the Loss and Gain values by how wide you place the spread between the strike prices. You can also impact these ratios by whether you place the spread in-the-money, at-the-money, or slightly out-of-the-money.
You can learn more about different option strategies by downloading our free options booklet: 3 Smart Ways to Make Money with Options (Two of Which You Probably Never Heard About). Just click here.
And be sure to check out our Zacks Options Trader.
Disclosure: Officers, directors and/or employees of Zacks Investment Research may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material. An affiliated investment advisory firm may own or have sold short securities and/or hold long and/or short positions in options that are mentioned in this material.
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