Followup on DOTM bull call spread and DITM bull put spread

Thanks so much, Kenneth.  In fact, I don't believe we truly are on opposite sides of the discussion; I believe, rather, that our methodology or understanding or practice may differ.  My position (opinion) remains as it was all along: that OTM bull call strategies are the opposite of ITM bull put strategies, both from the point of view of debit vs. credit, and the deltas being positive vs negative, respectively.  Now, to address some participants' assertion that they are "the same," because they complement each other (call delta 0.01 vs. put delta -0.99=1) is not what my argument is all about.  My position has been all along that in an OTM bull call spread with a tiny delta, the underlying stock would have to make an enormous move to the upside for that delta to respond, and for the spread to increase in price, and therefore be favorable to the buyer; while a similar enormous move to the upside on the ITM put spread would substantially decrease the cost of the put spread in favor of the seller, because of the delta near -1, that implies an almost 1:1 move of the options in relation to a move in the stock.  Both positions are bullish.  The call spread costs very little to enter, true, but would require too high a move to be influenced positively; while the opposite is true for the put. 

Whether my understanding of deltas (and thetas, in this case because of the very short expiry) is supported by the other participants in this debate is irrelevant.  This has been a hypothetical position all along, as I repeat, I would never select a front-month expiry for such positions, and I almost never, ever buy OTM calls.  My own methodology, if I wish to buy calls, especially OTM calls, would be to go very far off into the future to allow them time to fulfill their promise.  I'm generous that way.  As stated previously, my own preference in regards to puts is to do OTM naked puts or bull put spreads, but OTM (at a price less than the current stock price).

My hypothetical positions on AAPL, the subject of this debate, have been placed as a virtual trade on a great new platform that is currently a private beta, going public in the near future (preferred browsers include Chrome/Safari/Firefox).  To see my two spreads dance to the music in real time, please click on http://www.tradeclique.com/trader/yaelt#yael.

Another reminder of my preferences is that I generally do not wait for expiration.  I got burned badly in the 1999-2000 dot.com.  Whether it costs more or less in commissions is irrelevant to my peace of mind.  In the hypothetical ITM bull put spread above, since it was placed with a view that AAPL would make a substantial move to the upside by the Sep. 12 unveiling of a new iPhone, my preference would be to close down my put spread as soon as it presented a "significant" profit. I put that in quotations because I cannot tell you what I would consider significant, as to time to expiry is so short.  However, again, hypothetically, since I received a credit of $1800 for this trade, I might consider buying it back to close at, say, $1200 or so, being quite delighted with a profit of $600 in a few days' time (we placed this hypothetical trade around the beginning of Sep.).

Delta, the positive and negative

I came across a misconception about the deltas for puts and calls.  Someone put forth that a Sept. expiry Bull Call Spread on AAPL was the same as a Sept. expiry Bull Put Spread with similar strike prices.  In fact, the two strategies are diametric opposites.  That is because calls and puts do NOT have the same deltas, even when accounting for the fact that put deltas are represented by a negative number.  So, the AAPL Sept. 710 call has a delta of .0159 and the Sept. 730 call has a delta of .0000.  Since a Bull Call Spread is a debit spread, the cost for this spread is tiny, $.10 x .02=$.08 per contract, or $8.  The same strikes for the AAPL Sept. puts are 710 delta of -.9786 and the 730 put delta is -.9942.  Since a Bull Put Spread is a credit spread, the credit received would be $18.50 on a $20 spread, i.e., $1850 credit for every $2000 margin (but the "real" or effective margin is only $150=2000-1850). 

But, and this is a HUGE but -- with September expiry, you are giving no time at all for the stock to move.  Sept. expiry has an enormous theta influence (meaning time erosion).  If you buy the Bull Call Spread, it would cost you nearly nothing ($0.08 or $8 per contract), but the likelihood of that spread rising are almost nil, zero, zilch.  You know why?  Because the delta is 0.  The delta determines how much the option will move for every $1 move in the underlying stock.  With a delta of 0 and only 3 weeks to expiry, you would need a miracle for your $8 to go anywhere.  Of course, $8 is not a lot of money, so you may want to play with it.  But that would represent the true analogy to a lottery.

As for the Bull Put Spread, even though the credit is enormous, the Sept. expiry still poses a problem because of its short nature.  Yes, the deltas are huge (and are represented with a negative sign), which imply just about a 1:1 move of the options for every $1 move in the stock, but again, you are giving a very short time for the stock to do anything.  Very risky.

I am in the process of writing a book on this.  Stay tuned, if you're at all interested

Adjusting the Legs

Yesterday, I set up a Strangle With a Twist on Netflix (NFLX) right before earnings.  NFLX came out with earnings which were very positive, but "guided" lower.  The stock dropped in after-hour trading, and is trading considerably lower this morning, down about $16.75 at this writing.

Recall that I had two spreads on the stock: May 2011 $260-$265 Bull Call Spread and the May 2011 $235-$240 Bull Put Spread.  Both spreads are bullish; both spreads were set to expire May 2011.

With the stock currently down about $16.75, the call options are trading lower (the call options are currently out of the money - OTM), while the put options are trading higher (the put options are currently in the money - ITM), I have executed a few adjustments, as follows:

I bought to close (BTC) the May 2011 $265 call options for $2.90 ($290 per contract).  I sold them yesterday at $9.75 ($975 per contract), so my profit on this leg is $6.85 ($685 per contract).  That leaves a Long Call at the $260 strike expiring May 2011.  This is a Long Call (Long means that I own this position), therefore, there is no Margin Requirement.

I sold to close (STC) the May 2011 $235 put options for $10.35 ($1,035 per contract).  I bought them yesterday at $8.25 (of $825 per contract), so my profit on this leg is $2.10 ($210 per contract).  That leaves a Naked Put at the $240 strike expiring May 2011.  This is a naked position, therefore, there is a Margin Requirement of $5,977. 00.

Why did I adjust these legs?  From past experience, it seems that there is a knee-jerk reaction to negative news, and I am betting that the selling action is overdone, and the stock will recover.  So far, by removing those two legs (the short call* and the long put*), I have put $895 back into my account.  I opened both spreads yesterday at almost no cost to me.  My risk here is that the stock will not recover to the $240 strike naked put, in which case the stock will be put to me, and I will be obligated to buy it at the strike of $240 (refer to the lexicon for definitions).  As expiration approaches, I can reevaluate my position to see if the fundamentals of the stock are still interesting enough to wish to hold the stock, and if not, I can simply buy back to close that naked put, thereby relieving myself of that obligation.  In the event I do wish to allow the stock to be put to me, my break-even cost would be $240 (the strike price) less the profit of $895 I just realized, or $231.05.  Looking out to some long-term call options, selling a covered call would bring down the price even more.

With the stock currently trading at around $236, the $240 strike naked put is trading at around $12, which is $4 in the money (ITM) - $240-$236 - and a full $8 out of the money (OTM), or time value.  With May expiration being just 3 weeks away, the Theta of the option erodes extremely fast.  The Theta refers to how much value an option price will lose with every day that passes.  The closer to expiration, the faster an option loses value.

On May 11, 2011, the market started to jiggle (to the downside) a bit more than I like.  NFLX was trading up to $241, but then regressed down to $238, so I decided to roll out my naked puts to June 2011.  By rolling out, I closed (BTC) my May 2011 open position $240 Naked Put at $6.31 and opened (STO) a new June 2011 $240 Naked Put for $12.61, thus pocketing a profit on the May position of $3.74 ($374), and taking in a premium of $12.61 per contract ($1261) for the new June 2011 naked put.

Covered Calls With a Twist

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First, a definition: Covered Calls are Call options sold on stock that one owns.  One does that in order to generate income.

Say you own some shares of QQQ (an ETF of Nasdaq 100 shares).  The closing price on April 21, 2011 was $58.34.  You need a minimum of 100 shares of stock in order to be able to sell covered calls on those shares, therefore, your out-of-pocket outlay to buy those shares is $5834.00.  Assuming you own at least 100 shares, and you wish to generate some income, rather than simply waiting for continued increase in the stock itself, you search the option tables and various expiration dates, and determine that you would be happy to part with your shares at $59.  The May 2011 $59 strike call options are trading at $.55 bid x $.57 ask.  If you sell 1 contract per 100 shares of the May 2011 $59 strike calls, you will receive $55.00 into your account.  By doing so, you have committed yourself to part with the underlying stock at $59 by Friday, May 20, 2011.  Since the stock is currently at $58.34, selling it at $59 means an additional amount of $.66, or $66.00.  Add that to the $55 premium received for selling the calls, and your total gain is $121.00.  If you bought the QQQ at $58.34 and sold those calls, your return would be 2.07% for less than 4 weeks.  That translates to a return of 26.96% per year. 

What's the twist? You can buy call options on the QQQ and sell call options against the ones you own.  Remember from prior entries that you can buy Call options with any expiration date, and at any strike price.  Let's assume you are long-term bullish on the direction of the Nasdaq, and are willing to buy the basket ETF, the QQQ.  You do not want to monitor your position every day, so you buy the 2013 expiration $60 strike price, currently listed as $5.32 bid x $5.49 ask.  You buy at the ask.  Ten contracts which control 1000 shares cost $5490.00, essentially the same as buying 100 shares of the ETF itself.  In order to create a spread, and thereby mitigating your cost, you now sell calls against this position.  If you decide to sell the May 2011 $60 strike calls, you will receive $220 ($.22 bid x $.23 ask).  Assuming the QQQ closes at less than $60 by May 20, 2011, your total cost for the position will be mitigated down to $5268.00.  You can then sell the June 2011 $60 strike calls (or any strike, or any expiration).  If the QQQ does rise above $60, your total cost of $5268 will be recovered, PLUS any amount up to $60, in this hypothetical case, $6000-$5268, for a very decent return.

Bullish on BTU

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BTU is climbing in price, to a current $65 +/-.  I feel bullish long term on this stock.  Therefore, I have placed a bullish position to expire in 2013 for a credit of $500.  The entire position consists of a Bull Call Spread and Selling a Naked Put.

Bull Call Spread

BTO 2x 2013 $65 call @ ($18.35)

STO 2x 2013 $70 call @ $15.86

 

DEBIT: ($2.49) x2=($4.98)

 

-and-

STO 1x 2013 $65 put = CREDIT $11.20

Margin Requirement for the Naked Put $2,468.00