Option Spread Terminology: Confusion. Bull Call Spread vs Bull Put Spread

To my readers:  This is one of those lengthy, extra-detailed posts designed to proved a good answer to Carl's question.  I know the information is top-notch.  What I don't know is whether it's just too much.  I'd appreciate a bit of input:



Hi, Mark!


I’ve several questions about bull and bear vertical spreads

1) First off, the confusion factor arises from the fact that any vertical,
bull or bear, can be placed using all Calls or all Puts.

2) What is the best way to place a bullish vertical BELOW THE CURRENT PRICE
(using Puts or Calls)? Please develop this out with a couple of
scenarios with the pluses and minuses for each.

3) Which bullish vertical will be most likely to be assigned? Why?

4) Which bullish vertical has the most inherent adjustment capabilities?

5) Now, consider the case of a bearish vertical that is placed ABOVE THE
CURRENT PRICE.

This, I’m certain, is trivial for you, but my lack of knowledge is
costing me money.
Many thanks for your thoughts on this. 


Carl

***

Hello Carl,

The fact that this is costing money makes this question a priority for me.  I've incorporated enough materiel here to try to answer in detail.  I truly hope this helps you. By the way, this will be trivial to you also – after you understand it.  Don't be concerned about asking.  This is a very good and practical series of questions.

This is not complicated – but it can be confusing.  The confusion is through no fault of your own and I anticipate that I can eliminate your problem.  If there are further questions, or if something is not clear, please submit another comment.

1) Confusion indeed.  That's because most of the options world makes this far more complicated than necessary. There is no need to use all those adjectives to describe a simple position. If you think about these spreads as I suggest below, the confusion disappears.

Spread terminology

a) There are ONLY two types of simple vertical spreads:  Call spreads and  Put spreads

b) There are only two actions: Buy and sell

c) By definition

When you BUY a spread, you buy the option with the higher market price. 

When you sell a spread, you sell the option with the higher market price. 

[To clarify, if necessary: The 'price' above refers to the option premium, not to the strike price]

d) When you BUY a CALL spread it is Bullish (Thus, there is never a reason to refer to a bull call spread)

e) When you SELL a CALL spread, it is BEARISH (Thus, there's no reason to refer to a bear call spread)

f) When you BUY a PUT spread, it is BEARISH

g) When you SELL a PUT spread it is BULLISH

NOTE: Each of these examples is the same as buying or selling a call or put.  If buying a call is bullish, then buying a call spread is bullish.  Pretty simple, isn't it? 

Why anyone has to add an adjective such as bull or bear to a spread is beyond me.  And then they go further, by telling traders that you can buy or sell a bull put spread.  Then they teach that you can buy or sell a bear put spread.  Far, far too absurd for discussion. Too many words just add to the confusion.

h) If you choose to trade a put spread, then buying is bearish; selling is bullish.  That's exactly the same as when you buy or sell a put.

i) If you choose to trade a call spread, then
buying is bullish; selling is bearish.  That's exactly the same as when
you buy or sell a call.It just doesn't get an simpler than that.

Examples below

***

1) Remember this:  Carl – the fact that you already
understand that you can place a bullish trade with either calls or puts
is significant.  Many traders go for years without ever grasping that
simple concept.

To take it one step further, when the strike prices and expiry are the same, buying the call spread and selling the put spread are equivalent.  [In your, hopefully former, terminology, when you buy a bull call spread or use a bull put spread, you are making equivalent trades] That means that the expected profit and loss is essentially identical.

That also means it makes no difference which you trade.  This is important.  It makes no difference to the profit and loss. You can trade whichever is more convenient (more on this below).  There is no need to play out several scenarios.

Example: RGTO trades at 63

a) You can buy a call spread (buying the more expensive 55s)
Buy  RGTO Aug 55 calls
Sell  RGTO Aug 60 calls

You pay a debit of $X


b) You can sell the put spread (selling the more expensive 60s)

Buy  RGTO Aug 55 puts
Sell  RGTO Aug 60 puts

You collect a cash credit of $Y

When the markets are efficient, as they almost always are, X + Y = $5 (the difference between the strike prices x 100)

In other words, if you can buy the call spread by paying $3.80, you will be able to collect $1.20 for the put spread.  Either trade offers the same risk and reward.  Maximum gain: $1.20.  Max loss $3.80

If you grasp this truth, you are home.  If not, I discuss this concept of equivalent positions in greater detail in The Rookie's Guide to Options or in this blog post.


2) I prefer to trade options that are out of the money.  I recommend you do the same.  And there are two practical reasons (after all, the goal here is to save money -right?)

a) In general it is easier to trade less expensive options.  In the money (ITM) options  carry a much higher price tag (premium) than out of the money (OTM) options.  Why easier?  Because the market makers usually make tighter markets for OTM options.  That makes those options easier to trade.

Speaking of saving money, you do enter your orders as spreads don't you?  Here are two absolute rules that you must (for your benefit) obey:

i) Never enter a market order when trading options.  Use limit orders

ii) Always trade these call and/or put spreads using a spread (or combo) order.  DO NOT trade these spreads as two individual trades.  If you don't know how to trade spread orders, get on the phone with your broker's customer service people and get them to show you how to trade spread orders.  Be certain you understand the difference between buy and sell.  This is not an insult to you: some software can get confusing or your broker may use a strange terminology.

Thus, BELOW THE CURRENT STOCK PRICE, I SUGGEST SELLING THE PUT SPREAD because the calls are in the money and the puts are out of the money, and my advice is to trade OTM options.

Thus, the better bullish position, using options that are below the stock price, I would sell the 55/60 put spread.


3) Question 3 distresses me.  Which is more likely to be assigned? 

I trust that you understand: the only options that are assigned are IN THE MONEY OPTIONS, not out of the money options.  If you do not grasp this concept, it is too soon for you to be trading options.  To have any chance to succeed, you simply must understand how options work.

If you understand this, then your question is answered: Avoid selling options that are ITM and you face zero risk of being assigned.  Obviously OTM options can become ITM options when the stock price changes.  In that case, you once again face the possibility of being assigned.  But this risk is truly not a problem.  In fact, it is usually a benefit. 

Bottom line: by trading OTM  options, the chances of being assigned an exercise notice are far less than when trading ITM options.

I want to clarify:  You asked which vertical is more likely to be assigned.  You are never assigned on a 'whole' spread.  You can only be assigned on a single option – and it does not matter whether it is part of a spread.  Thus, I assume you mean: in which situation are you more likely to be assigned.  The answer is any time you are short ITM options you stand a chance of being assigned.

Thus, if trading the 55/60 call spread (stock is 63) it is possible to get assigned on the call with the 60 strike price.  However, the chances of getting assigned before expiration are very small.  And if it did happen it would be a gift to you.  Take my word for it, it would be a good thing (assuming there is no dividend involved).

Why does being assigned frighten you?  Can you let me know?  It is nothing to fear.  Of course if your reason is that it generates extra commissions and fees, then I understand.  That is something to avoid.

 

4) "Inherent adjustment capabilities."  As mentioned above – and perhaps you did not know this previously – the positions are  equivalent.  You can easily adjust either position in exactly the same way.  Neither has any advantage

I still prefer trading the less expensive, out of the money options, and suggest you do the same. 

5)  If you want to place a bearish trade
using options that are above the current stock price, then you can buy
the 65/70 put spread or sell the 65/70 call spread.  Reminder:  These
are equivalent positions.

I strongly suggest that you trade the
calls because they are OTM options.  Using ITM put spreads is a very
(and I mean very) bad idea.  Whereas it is unlikely that you would be
assigned an exercise notice ITM calls prior to expiration, that is
not true for puts. 

If a put is sufficiently ITM, and if
the put owner feels there is little chance that the put will move
OTM prior to expiration, it makes sense to exercise that put.  Let's
omit the rationale (for now) due to space considerations.

What you need to know is that selling ITM [AMENDED] puts is a poor choice.  Don't do it and I'll wager that your results
will improve right off the bat.  Those pesky assignments on put options
will cease. [To re-iterate, being assigned on calls is often beneficial]


Carl, I hope all of this is clear.  Please let me know if it is not.  And if you need more help – tell me why this is costing you money.

723



RookiesCover

"I want to thank you so very much for writing your wonderful introduction to
options. It's by far the best source of *useful* information that I have read. It explicitly addresses so many
questions that other, more technical works take for granted."  KS

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6 Responses to Option Spread Terminology: Confusion. Bull Call Spread vs Bull Put Spread


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