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To those students who started their options trading career by attending the 2-day intermediate Optionetics class, I give my heartiest congratulations on your decision to pave the way for financial independence. However, you need to understand that it is not a short journey and you will be learning new things every day. My objective is a simple one – to help you to succeed in achieving your goals.

One common misconception I notice among the beginners relates to the vertical spread, and in particular the credit spread. Have you ever heard of this – “Wow, credit spread is the best options strategy because you can initiate the trade for a C-R-E-D-I-T!” Folks, I hope after reading this article, you will understand that there is no such thing called “initiating a vertical spread for a credit.” In fact, you will understand that a vertical credit spread is indeed a vertical debit spread synthetically. So, there is nothing fancy about being a “credit spread specialist.”

Illustration

Suppose you have done your analysis and are bullish on Apple Inc (AAPL). AAPL is currently trading at $182.22, and you have a target of $200.00 by January 2008 expiration (Caveat – this is not a trade recommendation, but merely an illustration of the concept of vertical spread). Again, I need volunteer to help me in this case study. (Bok, thank you for helping me again.)

Bok’s Options Analysis

Bok has been using Platinum for years, and he knows a lot of features that I may not even know (for the record, I have only used Platinum since mid-2004). He has picked a credit spread strategy known as “selling a put spread” using Jan08 options. He plans to sell a Jan08 200 put and buy a Jan08 190 put for a credit of $6.20 (see Chart 1).

Chart 1: Risk Graph of AAPL Jan08 190-200 Put Spread
(Source: Optionetics Platinum)

Bok is telling himself, “Wow, this is a good trade” because he can initiate it for a credit of $6.20. In fact, he is smiling because he thinks the broker pays him to initiate this trade. Is this correct?

Let’s pause for a moment because I would like you to look at the greek profile for this trade. No doubt the delta is a positive number. Please take a look of the theta value. It is negative, meaning if AAPL does nothing between now and Jan08 expiration, the vertical spread will lose value day by day. So, you may wonder whether a credit spread is always an income strategy. As you can see from this example, the answer is no because it all depends on how you construct the trade in the first place.

Jack’s Options Analysis

Let’s start with this proposition – a vertical credit spread is synthetically the same as a vertical debit spread. How do I prove this?  Let’s look at Chart 2, which is an options strategy known as “buying a call spread.” Here, I will buy a Jan08 190 call and sell a Jan08 200 call.

Chart 2: Risk Graph of AAPL Jan08 190-200 Call Spread
(Source: Optionetics Platinum)

Do you notice something? Both the put spread (Chart 1) and call spread (Chart 2) have a maximum risk of $380. The difference between Chart 1 and Chart 2 perhaps is that the amount of $620 is reflected as a credit in Chart 1 and maximum reward in Chart 2. That said, you should now realize that both trades are synthetically the same. Even if you do not have Platinum, you can work out the basic using simple mathematics.

1. A 10-point box can only be worth a maximum of $10.
2. If you initiate a 10-point call spread for a debit of $3.80, you should expect the synthetic put spread to be worth $6.20.
3. If you decide to buy the 10-point call spread for a debit of $3.80, you should know that your maximum reward will be $6.20 ($10 - $3.80). Generally, you will achieve the maximum reward when AAPL closes above $200 at Jan08 expiration.
4. If you decide to sell the 10-point put spread for a credit of $6.20, you should know that your broker will reduce your buying power (i.e. the net margin) by $3.80 ($10 - $6.20). Generally, you will be able to keep the credit in full when AAPL closes above $200 at Jan08 expiration.
5. So, in both cases, you have the same maximum risk and maximum reward profile. Is there a reason to be ‘a credit spread’ specialist?  I hope you will say ‘no’ by now.

Some Observations

Having proven that a debit spread is synthetically the same as a credit spread using the options in the same month, and using the same strikes, you may now ask which one you should pick, and under what circumstances. These are good and valid questions. Let me offer my two cents here:

1. If you are beginner, my honest suggestion is for you not to sell any in-the-money [ITM] put spread (e.g. the trade in Chart 1) unless you understand the implications of early exercise and assignment. My experience is that most beginners do not understand this concept, and even if they do, they may not have sufficient real life experience to deal with this issue calmly. In the Principle of Market Making [POMM] Class, Alex Mendoza and Greg Loehr discuss this concept in detail. So, make it a point in your career to attend the POMM Class.
2. Okay, if you think you have passed the beginner’s stage, you should always as an additional options analysis step, consider the value of the box. What do I mean?  If the value of the box is above $10 (which can happen because the market makers are constantly adjusting their bid/ask during the trading hours), you should consider selling the put spread. The idea is that if the box is worth more than $10, thereby creating a potential arbitrage opportunity, you will be better off being the seller if the box value is to be adjusted downward. On the other hand, if the box is worth less than $10 currently, you will be better off being the buyer if the box value is to be adjusted upward. Although we are not allowed to recommend any brokers to you, some brokers I know have capability of showing you in their platforms the value of the spread based on natural price and the mid-point. So, you can compare the mid-point value of the put spread and the call spread by merely a few clicks and you should be able to tell whether you want to sell the put spread or buy the call spread. Don’t take my words for granted. Go ahead to check with your brokers.

Good trading!

Jack Wong 
Staff Writer
Optionetics.com ~ Your Options Education Site

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