The credit call spread and the debit call spread appear to be exactly opposite in every respect. Many novice traders perceive credit spreads to be fundamentally different from debit spreads. That is not necessarily so. Closer study reveals that these two are not so different after all.What if Apple’s stock price was higher when the trade was put on? What if the stock was at $405? First, the spread would have had more value.
The 395 and 405 calls would both be worth more. A trader could have sold the spread for a $5.65-per-share credit. The at-expiration diagram would look almost the same. See Exhibit 9.6.Because the net premium is much higher in this example, the maximum gain is more—it is $5.65 per share. The breakeven is $400.65. The price points on the at-expiration diagram, however, have nothing to do with the greeks.
The analytics from Exhibit 9.5 are the same either way.The motivation for a trader selling this call spread, which has both options in-the-money, is different from that for the typical income generator.When the spread is sold in this context, the trader is buying volatility.Long gamma, long vega, negative theta. The trader here has a trade more like the one in the bull call spread example—except that instead of needing a rally, the trader needs a rout.
The only difference is that the bull call spread has a bullish delta, and the bear call spread has a bearish delta.Bear Put Spread:There is another way to take a bearish stance with vertical spreads: the bear put spread. A bear put spread is a long put plus a short put that has a lower strike price. Both puts are on the same underlying and share the same expiration month. This spread, however, is a debit spread because the more expensive option is being purchased.
Imagine that a stock has had a good run-up in price. The chart shows a steady march higher over the past couple of months. A study of technical analysis, though, shows that the run-up may be pausing for breath. An oscillator,such as slow stochastics, in combination with the relative strength index (RSI), indicates that the stock is overbought. At the same time, the average directional movement index (ADX) confirms that the uptrend is slowing.
For traders looking for a small pullback, a bear put spread can be an excellent strategy. The goal is to see the stock drift down to the short strike.So, like the other members of the vertical spread family, strike selection is important.Let’s look at an example of ExxonMobil (XOM). After the stock has rallied over a two-month period to $80.55, a trader believes there will be a short-term temporary pullback to $75. Instead of buying the June 80 puts for 1.75, the trader can buy the 7580 put spread of the same month for
1.30 because the 75 put can be sold for 0.45.1
Buy 1 ExxonMobil June 80 put @ 1.75
Sell 1 ExxonMobil June 75 put @ 0.45
Net debit 1.30
In this example, the June put has 40 days until expiration. Exhibit 9.7 illustrates the payout at expiration.If the trader is wrong and ExxonMobil is still above 80 at expiry, both puts expire and the 1.30 premium is lost. If ExxonMobil is between the two strikes, the 80 puts are ITM, resulting in an exercise, and the 75 puts are OTMand expire. The net effect is short stock at an effective price of $78.70.
The effective sale price is found by taking the price at which the short stock is established when the puts are exercised—$80—minus the net 1.30 paid for the spread. This is the spread’s breakeven at expiration. If the trader is right and ExxonMobil is below both strikes at expiration, both puts are ITM, and the result is a 3.70 profit and no position.
Why a 3.70 profit? The 80 puts are exercised, making the trader short at $80, and the 75 puts are assigned, so the short is bought back at $75 for a positive stock scalp of $5. Including the 1.30 debit for the spread in the profit and loss (P&(L)), the net profit is $3.70 per share when the stock is below both strikes at expiration.This is a bearish trade. But is the bear put spread necessarily a better trade than buying an outright ATM put? No.
The at-expiration diagram makes this clear. Profits are limited to $3.70 per share. This is an important difference. But because in this particular example, the trader expects the stock to retrace only to around $75, the benefits of lower cost and lower theta and vega risk can be well worth the trade-off of limited profit. The trader’s objectives are met more efficiently by buying the spread.
The goal is to profit from the delta move down from $80 to $75. Exhibit 9.8 shows the differences between the greeks of the outright put and the spread when the trade is put on with ExxonMobil at $80.55. As in the call-spread examples discussed previously, the spread delta is smaller than the outright put’s. It appears ironic that the spread with the smaller delta is a better trade in this situation, considering that the intent is to profit from direction.