Understanding Basic Option Spreads - Part Two
...continued from Part One
Time Value Is The Key
Investors often wrongly assume that because you take in premium andpost margin with a credit spread, your position is always comparable tooption writing. In fact, what really determines if a spread is like anoption sale or purchase is whether the investor is selling or buyingtime premium on a net basis.
Remember that at-the-money or closeto-the-money options always have more time value than options that arefurther out-of-the-money or deeper in-the-money. If you are buying anoption that is closer to the money than the one you are writing, thenon a net basis, you are a buyer of time premium.
If you are writing anoption that is closer to the money than the one you are buying, then ona net basis, you are a seller of time premium. In both examples below,you are a net seller of time premium even though with the debit spread,we actually pay a premium.
Examples - Bull Call vs. Bull Put
Somewhat surprisingly, credit spreads usually require approximately thesame amount of capital to establish as do debit spreads involving thesame strikes. (The examples below will help illustrate this point).
In Figure 1 (check back soon for a downloadable version of Figure 1), we compare two spreads on Moodyís Corp., a bull callspread and a bull put spread. In each one we buy the $45 strike optionand sell the $50 strike option (with the Moodyís common at $50).
In thebull call spread, we pay $5.60 for the $45 call and we receive $2.00for the $50 call with a net debit of $3.60 per share or $360 on aspread involving one option on each side. This spread is a little likea covered call in which you use the long $45 strike call as asubstitute for the stock and where you write the $50 call against it.
Notice that the $45 call has only $0.60 in time premium and that youare taking in $2.00 worth of time premium with the call that you wrote.Your net credit of time premium is $1.40 per share -or $140 for thespread. If the stock ends up at $50 or above, you get to keep this $140net time premium, net of transaction costs.
In the bull put spread, we write the $50 put at $1.85 and buy the $45put at $0.50 as a hedge against losses below $45. This spread issimilar to a "naked" put write; the difference, however, is that wehave covered the downside by buying the lower strike put.
In thisexample, the net premium received is $1.35 or $135 on a spread with oneoption on each side. With the credit of premium applied to the margin,the capital requirement is $365 on the spread. If the stock ends up at$50 or above, you get to keep the entire $135 credit of premium on theposition.
Concluded In Part Three
Posted By: Value Line
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About Lawrence D. Cavanagh
Lawrence D. Cavanagh is Editor (and Senior Analyst) of The Value Line Daily Options Survey. The Value Line Daily Options Survey offers evaluations and rankings on virtually the entire universe of regularly listed equity and ETF options, using the Value Line common stock ranks and proprietary volatility forecasting methodology. Before joining Value Line in 1991, Mr. Cavanagh was an options strategist for Capital Market Technologies (subsidiary of Elders Finance), helping design long-term synthetic foreign currency and gold option hedges. Before that, he was Director of Foreign Currency Options for the Chicago Board Options Exchange. Other work experience includes Dean Witter Reynolds (VP, Senior Currency Analyst), European American Bank (Director of Currency Forecasting) and the Federal Reserve Bank of New York (Assistant Economist).
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