Friday, March 19, 2010

Basic Short Spreads

While I hoped to get into some volatility spreads today, I felt it might be valuable to cover basic short spreads first. This shouldn't take much time since we already discussed basic long spreads and they are after all the same thing. What? Yes you read that correctly: the most important thing to remember is that, given the same strikes, selling a call spread yields the same payoff function as buying a put spread and vice versa. Long time traders are well aware of this but it is a point that is frequently missed by less experienced option traders. I have included two charts 1) a short position in the 40-41 call spread and 2) a long position in the same strike put spread for the Retail SPDR (XRT). As you can see, they produce the same break even scenario based on a transaction that could have been executed bid to ask at yesterday's closing prices.

These spreads are perfectly aligned, as they should be, and emphasizes the point that when you subtract the cost of buying a call spread from the difference between the strikes, you should have the price you would be able to get if you sold the same strike put spread. Occasionally, you will find a situation where the options are out of whack, which might provide an astute trader who understands this relationship to find a little more edge in a trade. Of course if things become too skewed, someone, or more likely one of the many algorithms that are out there, is going to hit bids and take offers until it get back into line.

So the question becomes, why choose one over the other? Unless you can find a way to get a better price in one over the other, it makes absolutely no difference. Even when you consider the skew or smile of implied volatility in a given month, since the strikes are the same the implications of the two spreads are identical for shifts in volatility and over time. The XRT spreads used in the example are right at the money, but if you were using lower strike options (in-the-money calls/out-of-the-money puts) you might expect to find some advantage in buying the put spread as opposed to selling the call spread given a normal skew or smile, but if the market makers are doing their job, this simply isn't the case.

The bottom line is that if you are looking to buy a basic 1-to-1 be sure that you check out the other side of the board to make sure everything is in line, occasionally you might be able to save yourself a few pennies because some misalignments might be too small for an algorithm to capitalize on but could reduce your cost. A quick example: Say you are intending to buy a $5 call spread that is offered at $1.25, the put spread should be $3.75 bid, but maybe it is $3.80 bid. That translates into paying $1.20 for the call spread which is obviously a better choice for you. In today's world of electronic markets these things change quickly and it pays to be aware of your options (pun intended).  Happy Friday!

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