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A Call is a Put and a Put is a Call - Even in Spreads

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“A call is a put and a put is a call.”

When I first went to work for an options market-making firm 22 years ago, I heard that phrase many times every day. The wily options-trading veterans that trained us drilled it into our heads until it became second nature.

They were trying to make sure we understood the principle of call-put parity.

By the time I was responsible for my own position about a year later, the reports I looked at detailing the options I held (or was short) strike by strike, didn't even differentiate between puts and calls - it aggregated the total on each strike because the diifference was meaningless to me. 

That same logic applies to spreads as well.

This week, during a conversation with two colleagues, we were discussing methods of analyzing the profit profitability of various bull call vertical spreads.

When discussing an in-the-money vertical spread, I offhandedly commented that I’d probably never trade in-the-money options on purpose because of the lower liquidity and wider spreads, and that I’d just sell the put spread instead.

I understand this can be counter-intuitive, but I promise I can make it make sense.

The spread:

Let’s say you thought that shares of the Walt Disney Company (DIS - Free Report) – which currently trade around $139 - were going to continue to drift higher through the rest of 2019 and had little chance of a steep decline.

You decide to buy the 115 calls that expire in January 2020 and sell the 120 calls. As long as Disney stays above 120, that spread will be worth exactly $5 at expiration.

If you buy the spread for a net debit of $4, and Disney stays above 120 between now and expiration, you’d make $1 per spread - your $4 premuim becomes $5. 

If the shares are below 115, you’d lose the entire $4 in premium you spent.

Your breakeven is $119/share.

The p/l diagram looks like this:

But, if you instead sold the 120 puts and bought the 115 puts for a credit of $1, your profit potential and risk are the same. If Disney stays above $120, you keep $1, below $115, you lose $4. Breakeven is $119/share.

It's exactly the same!


Here are the recent market prices of those options:

                                Bid                          Ask

115 Call                $25.80                   $26.05

120 Call                $21.60                   $21.85


If you bought the offer on the 115 call and sold the bid on the 120 call you’d pay a total of $4.45. If Disney stays above $120/share between now and expiration, you’d make a profit of $0.55/spread. If the shares are below $115 at expiration, you’d lose the entire $4.45 in premium you paid.

Here are recent market prices for the puts:

                                Bid                          Ask

115 Put                 $1.87                     $1.92

120 Put                 $2.73                     $2.78

In this case, if you sold the bid on the 120 put and bought the offer on the 115 put, you’d collect $0.81. This becomes your maximum profit, almost double the maximum profit on the call spread, and also reduces your maximum risk to $4.19.

In this example, it’s easy to see that the culprit is the width of the bid/ask spread. The in-the-money calls are $0.25 wide and the out-of-the-money puts are only $0.05 wide.

The amount of bid-ask spread you pay when entering a trade can significantly skew your chances of profitability. 

Even though it might seem scarier to sell a spread than buy one, in actuality they have exactly the same risk/reward profile. By selling the put spread instead of buying the call spread, you can change the potential for profit significantly in your favor.

The upshot is that if you’re considering trading in-the-money options – even as part of a spread – it’s very likely there’s a more attractively priced trade in out-of-the-money options that accomplishes the same risk/reward goals at a more attractive price.

Just remember – “A call is a put and a put is a call.”


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