S&P500 Simplified : Calls vs Puts

The first item to clarify when it comes to trading anything is that buying a security or derivative (option) involves forecasting the move in price. The move must be in favour of the trade and, with options, must make that favourable move in some chosen time frame. Considering that the price can go up, down or even sideways, a very base assumption is that just buying options I can be correct maybe a third of the time, although with stocks they can be held indefinitely so there is less of a time factor, perhaps it's fair to say that the odds are near 50%. There are strategies that can mitigate and help to produce larger winners than losers but, as I have found out, they are often not as simple as at first thought.

In my last post I had briefly outlined the difference between naked options and spreads, specifically trading the puts which can be a fairly neutral strategy in that the price of the underlying stock can move up, sideways and even down a certain amount and the trade will still produce a profit. This can change the base 33% odds to higher than 50%. Anything over 50% is the edge that can be used to produce more winning trades than losers but even that is often not enough to make a trade strategy profitable. More on the stats in the next post.

The main reason for choosing put spreads instead of call spreads has to do with the price skew between calls and puts. Today SPY closed at $179.87. Comparing the equal (more or less) strike distanced 190 call selling for 9 cents and the 170 put options selling for 51 cents. In the case of the credit spread, the higher priced option produces a higher profit trade.

A note about the pricing structure of the options used in this sort of strategy.

A put has intrinsic value when the stock price is below the strike. This value is equal to the difference between the strike and the price and changes in direct proportion to any changes in the price of the stock. The credit spread uses options that are OTM and do not have any intrinsic value.

In it's simplest form, the extrinsic or time value is a calculated price or premium based on the volatility of the stock (expected and historical range of price moves), proximity of the strike to the price and the time left until it's expiry. This value reduces or decays as the expiry date approaches, as the price wanders higher making the option farther OTM and as the volatility reduces. A credit spread uses this decaying extrinsic value in it's favour as the credit gained at the initial sale is kept as the options expire with a zero value at expiry. The only factor that can produce a losing trade is the price dropping below the put strike so a directional move up is better for the position but isn't critical. Time can only reduce and, while volatility can affect interim trade value, it won't matter as long as the price stays higher than the strike. A sharp reduction in volatility in a few days can turn the trade into a quick winner and can allow it to be closed early... but that is a whole other topic.

Here is the comparison between the two vertical spreads, a call and a put, with the same $5 width or spread, these are based on the SPY December 2013 monthly option prices:

Call Spread				Put Spread
$0.06		Net credit in green		$0.24
$0.03	Buy	195 strike
$0.09	Sell	190 strike
		SPY Price 179.87
		170 strike	Sell	$0.51
		165 strike	Buy	$0.27

In a 10 contract trade the call spread will produce $60 (1.2% Return On Capital, ROC) and the put spread $240 (4.8% ROR). This disparity is typical between OTM calls and puts on most any underlying stock or fund. That's an even 300% higher return.

This pushes me to look for an edge that favours a put credit spread even though I expect that there may be better odds in favour of the call spread, the reduced profitability won't make up for the difference... particularly in a small account..

Jeff.