Credit spreads risks and rewards
- Posted by Richard Croft on September 6, 2007 filed in Options Market
Derek makes an interesting comment that I think requires more than a simple one-line reply.
Notable is his point about the risk reward ratio in last week’s blog not being equal to at least one. For clarification, the maximum profit on the Telus bull put spread example – assuming the stock stayed at the top of its trading range - was the $2.50 net credit. The risk was $3.50 should Telus fall below the strike price of the long put. If the stock fell, the risk was greater than the reward.
In fairness, Derek also pointed out – correctly - that risk reward may not be the primary driver in a position where your goal is to take possession of the stock. Which was what last week’s blog was all about.
Having said that, the risk reward ratio is a consideration if you are using spreads as a trading strategy. In fact, the one to one risk reward ratio may be relevant.
The problem is that you can only attain a one to one ratio if you are working with in-the-money spreads. When involving a credit spread, the option you sell is in-the-money, whereas the option you buy is typically out-of-the-money or in some cases, in-the-money.
To make the point, let’s examine a series of three month options on a hypothetical XYZ which is trading at $100 per share, with the options implying a 40% volatility. The theoretical option prices can be found in the accompanying table.
| Calls | Strike | Puts | ||
|---|---|---|---|---|
| 14.27 | 90.00 | 3.20 | ||
| 11.12 | 95.00 | 4.99 | ||
| 8.48 | 100.00 | 7.28 | ||
| 6.32 | 105.00 | 10.07 | ||
| 4.62 | 110.00 | 13.31 |
With the stock trading at $100 per share, the only way to get a one to one or better ratio is to write in-the-money puts (i.e. the 110 or 105 strikes) and buy at-the-money puts or out-of-the-money puts. But that means, the maximum return can only be earned if the stock rises. And there lies the rub!
I believe, when using credit spreads (in the XYZ example we are using a bullish [put] credit spread) the objective is to make the maximum profit if the stock remains unchanged. Which means writing the at-the-money puts and buying the out-of-the-money puts (i.e. writing the 100 strike and buying the 95 or 90 strike).
If you are seeking one to one ratios with credit spreads, then generally, the underlying stock must move… up in the case of a put credit spread or down in the case of a call credit spread. If that is what you are expecting, then why not simply buy a call or a put and get full value for the move.
Just a thought!
October 4, 2007 at 1:50 am
Wow good answer.
I am about a month behind and forgot i even replied to this. In response to your last paragraph that is all i do with options.
I keep it mostly simple. I buy either puts or calls. That is mostly my only thought. At times i look at buying the underlying security, lately BVF and PWT.un, then purchasing a put deep in the money to protect.
Capital outlay is more, but my risk is almost nil if i hold for several months and collect the dividends till expiry.
Then if the stock moves up sharply i can profit from the move and on the other hand if our markets get hammered i break even.
Derek
disclosure: I own bvf, bvf calls and protective puts on shares. Didn’t not buy PWT.un last week but wished i had..