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Option Spreads: Putting the Odds in Your Favor

 August 08, 2007 11:09 PM

 Option spreads, created by buying an option and simultaneously selling a related option, are seldom the choice investment vehicle of position traders, especially beginning traders, largely because of their intuitive complexity and difficulty of execution. However, option spreads arguably offer better expected risk/return characteristics than futures and even outright purchases of call or put options so that over time option spread strategies can yield greater risk-adjusted rates of return and overall portfolio performance.

Common Types of Spreads

Of the many option spreads available, the two more common are the bull call spread and the bear put spread. These spreads are regarded as debit spreads since the purchaser must pay the initial cost of the spread and this, including commission and fees, constitutes all of the market risk of the position. A bull call spread consists of buying a call option and simultaneously selling another call option of the same commodity and expiration but having a higher strike price. A bull call spread creates a long exposure and is established when the trader expects prices to rise. It thus provides an alternative to buying a futures or buying a call option. A bear put spread consists of buying a put option and simultaneously selling another put option of the same commodity and expiration but having a lower strike price. A bear put spread creates a short exposure and is established when the trader expects prices to fall.

[Related -Savings Glut and Financial Imbalances]

Exhibit One displays possible spread combinations from sample gold option prices and calculates the maximum risk (i.e., the cost) and the maximum net gain of each. Since the price of the futures at the time of the option's expiration is unknown, each of the maximum net gain values must be weighted by the probability of occurrence (not shown) before a realistic comparison can be made across the various positions. For instance, even though the 300/320 bull call spread has the highest maximum net gain of $1,640, the low probability of gold rallying to $320 per ounce by the option's expiration may make this spread less desirable than others that rely on more likely scenarios.

Exhibit One: February Gold futures settle price: $295/ounce
Feb Gold Options - Calls Feb Gold Options - Puts
Strike Price $ Value Strike Price $ Value
300 6.6 $ 660 290 6.5 $ 650
310 4.0 $ 400 280 3.5 $ 350
320 3.0 $ 300 270 1.7 $ 170
Possible Bull Call Spreads:
Buy Sell Max. Risk* Max. Net Gain*
300 strike 310 strike (660-400)= $260 (310-300)x100-260= $740
310 strike 320 strike (400-300)= $100 (320-310)x100-100= $900
300 strike 320 strike (660-300)= $360 (320-300)x100-360= $1,640
Possible Bear Put Spreads:
Buy Sell Max. Risk* Max.

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Using Options to Protect a Futures Position
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