This report is part of an ongoing series on option spreads. Spreads are combinations of different option positions on the same stock. Spreads are really not that complicated once you understand a few basic principals. The spreads that we will cover in this series will all have limited risk. Some of them can offer investors very efficient use of their capital.

Bull vs. Bear

You create basic bull and bear spreads by simultaneously buying and writing calls or puts (not both) on the same stock with the same expiration but with different strike prices. The risk/reward characteristics of the spread will depend on the price and the strike prices of the options you buy and the options you write.

You have all heard "buy low, sell high if you are bullish." This adage can help you remember how to structure your spreads.

Bullish: Buy Low and Sell High. In a bull spread, the investor simultaneously buys the lower strike call (or put), and sells the higher strike call (or put).

Bearish: Buy High and Sell Low. In a bear spread, the investor simultaneously buys the higher strike call (or put) and sells the lower strike call (or put).

Debit vs. Credit

The required margin on a credit spread is equal to the difference between the two strike prices times the number of underlying shares. This amount represents the most the investor can lose on these positions (e.g., $1,000 for an option on 100 shares with the strike prices $10.00 apart). However, your actual capital requirement is reduced by the fact that you are allowed to apply the net credit of premium to this margin.

In contrast, margin requirements on "naked" option writes can be hefty. Here, you are required to post the entire premium taken in plus a percentage of the underlying value (20%, less the amount out-of-the-money, or 10%, whichever is greater).

A Bull Put Spread from a "Naked" Put Write Recommendation

Debit Spreads: Bull spreads constructed with calls (bull call spreads) and bear spreads constructed with puts (bear put spreads) require that you pay a net payment of premium, since you are buying the higher premium option and selling the lower premium one. We call these spreads "debit spreads," because your broker debits your account for the net premium amount. With a debit spread, the most you can lose is this net premium you paid, while your potential gains are limited by the option you wrote. The Exchanges do not require a margin on debit spreads.

Credit Spreads: Bear spreads constructed with calls (bear call spreads) and bull spreads constructed with puts (bull put spreads) always involve selling the higher premium option and buying the lower premium one. We call these spreads "credit spreads" because your broker credits your account with the net premium. With these spreads, the Exchanges require that you post a margin equal to the difference between the two strike prices. This margin covers your maximum possible loss on the spread. With a credit spread, you are allowed to apply your net credit of premium toward this margin requirement.

Time Value is the Key

Investors often wrongly assume that because you take in premium and post margin with a credit spread, your position is always comparable to option writing. In fact, what really determines if a spread is like an option sale or purchase is whether the investor is selling or buying time premium on a net basis. Remember that at-the-money or close to-the-money options always have more time value than options that are further out-of-the-money or deeper in-the-money. If you are buying an option that is closer to the money than the one you are writing, then on a net basis, you are a buyer of time premium. If you are writing an option that is closer to the money than the one you are buying, then on a net basis, you are a seller of time premium. In both examples below, you are a net seller of time premium even though with the debit spread, we actually pay a premium.

Examples - Bull Call vs. Bull Put

Somewhat surprisingly, credit spreads usually require approximately the same amount of capital to establish as do debit spreads involving the same strikes. (The examples below will help illustrate this point).

In Figure 1, we compare two spreads on Moody’s Corp., a bull call spread and a bull put spread. In each one we buy the $45 strike option and sell the $50 strike option (with the Moody’s common at $50). In the bull call spread, we pay $5.60 for the $45 call and we receive $2.00 for the $50 call with a net debit of $3.60 per share or $360 on a spread involving one option on each side. This spread is a little like a covered call in which you use the long $45 strike call as a substitute for the stock and where you write the $50 call against it. Notice that the $45 call has only $0.60 in time premium and that you are taking in $2.00 worth of time premium with the call that you wrote. Your net credit of time premium is $1.40 per share -or $140 for the spread. If the stock ends up at $50 or above, you get to keep this $140 net time premium, net of transaction costs.

In the bull put spread, we write the $50 put at $1.85 and buy the $45 put at $0.50 as a hedge against losses below $45. This spread is similar to a "naked" put write; the difference, however, is that we have covered the downside by buying the lower strike put. In this example, the net premium received is $1.35 or $135 on a spread with one option on each side. With the credit of premium applied to the margin, the capital requirement is $365 on the spread. If the stock ends up at $50 or above, you get to keep the entire $135 credit of premium on the position.

Which Spread is Best?

Not only do these two spreads, constructed by buying the $45 strike option and selling the $50 strike option, require similar amounts of capital and have similar maximum losses ($360 for the bull call spread versus $365 for the bull put spread), they have similar maximum gains as well.

The maximum gain on the bull call spread is $140 if the stock ends up at or above $50. However, if the stock is sufficiently far above $50 ($0.75 beyond the strike is the trigger for automatic exercise); the investor will have to close out both the long call and the short call. This will incur both commissions and (possibly) losses on the bid and ask spreads.

The maximum gain on the bull put spread in this example is $135, which is $5 lower than with the bull call spread. However, if the stock ends up at or above $50, there are no further transactions required. You simply keep your premium. Another attractive feature of the bull put spread is that your broker usually will allow you to use other assets instead of cash (usually at an assets to cash ratio of a 5 to 4) to establish and maintain your spread.

In general, a simple way to figure out which spread would be the best (credit or debit) is to ask yourself where you expect the stock to end up. If it is a bull spread and you expect the stock to end up above both strike prices, then the bull put spread has the edge.

Searching for Spreads

At present, we do not specifically rank spreads, but we do provide a template (Spreadsearch2.Xls), with which you can find spreads that our model finds to be favorably priced. See "Searching for Spreads with Spreadsearch2.Xls," Ot041025.Pdf in our Reports directory. A recent search of our Puts.Csv file with Spreadsearch.Xls found 24 favorable spreads, in which the written put was close to the money, and in which the underlying stock rank was a 1 or a 2. The results are shown in Figure 2.

Evaluating Your Spread

You can use our Whatifi3.Xls position evaluation software to look at how your spread is likely to perform at different stock prices. In Graph 1, we show an example of one of the spreads selected in Figure 2. With the stock at $40.04, we have written the MGM November $40 put at $1.90 and bought the November $30 put on the same stock at $0.15 for a net credit of $1.75 (or $175 in a spread involving one option on each side). As you can see, the best outcome at $40 or above is a gain of $175 while the worst outcome at $30 or below is a loss of $825 (which is equal to your net capital requirement on the spread).

Additional Information

If you are not a subscriber, but are interested in options, you may want to read the following reports in Educational Strategy Reprints: "Buying Naked Calls," "Buying Naked Puts" and "Covered Calls, Doing the Math."