|"When should I buy a vertical spread, and when should I buy an outright call or put?" If you have ever asked this question, you are not alone. |
This article will explain why vertical spreads are the strategy of choice for a certain type of forecast. A comparison of theoretical values for a long call and for a bull call spread provides several insights about when vertical spreads might be the preferred strategy. This article focuses on vertical spreads using calls, but the same logic applies to vertical spreads involving puts. For the sake of simplicity, commissions and margin interest charges are not included in the discussion.
A bull call spread is one type of vertical spread. With XYZ stock trading at $80.00, an XYZ 80-90 Bull Call Spread might be created by buying one XYZ 80 Call for 5.50 and, simultaneously, selling one XYZ 90 Call for 2.10. In this example, the net cost is 3.40, not including transaction costs.
Table 1 contains theoretical values of an 80 Call at various stock prices (rows) at various days prior to expiration (columns). Table 2 contains corresponding theoretical values for an 80-90 Bull Call Spread.
Tables 1 and 2 were created using The Options Toolbox, a computer program that can be downloaded free of charge from the web site of the CBOE (http://www.cboe.com).
Now consider a forecast for XYZ stock to rise from $80 at 40 days to expiration (Row 9, Column 1) to $86 at 10 days (Row 6, Column 4). Table 1 indicates that the 80 Call would rise from 5.50 to 6.80 for a price rise of 1.30. Table 2 indicates that the 80-90 Bull Call Spread would rise from 3.40 to 5.40 for a potential profit of 2.00. In this case, the 80-90 Bull Call Spread has both a larger dollar potential profit and a larger percentage potential profit, 58% versus 23%. In this case, the Bull Call Spread is the rational choice.
Tables 1 and 2 also contain negative outcomes. If the forecast for a stock price rise does not materialize, then the option prices will decline and a loss will occur. The maximum possible risk of buying calls and bull call spreads is the full cost of the strategy including commissions.
Options involve risk and are not suitable for all investors. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document are available from your broker or The Options Clearing Corporation, 400 S. LaSalle Street, Chicago, IL 60605. CBOE and Chicago Board Options Exchange are registered trademarks of the Chicago Board Options Exchange, Incorporated. 2003 Chicago Board Options Exchange, Incorporated, All Rights Reserved.
This article will explain why vertical spreads are the strategy of choice for a certain type of forecast.