Bull Call Spreads: Is Time On Your Side?
Bull Call Spreads: Is Time On Your Side?
On the last Friday in August, my friend Bob decided that Amazon (AMZN) at 126.64 was due for a bounce, so he decided to purchase a call spread.
Hereís the prices for various call options expiring October 15 (as of August 20):
Bob chose to buy an October 140 call for $179 and sell the October 150 call to collect a $53 credit. The net cost was $126.
Note: none of the figures in this post accounts for commissions.
This is an example of a bull call spread ñ buying one call option and selling another at a higher strike.
Selling the higher strike option reduces the cost of the spread, but it also caps the potential return. Buying a 140 call and selling a 150 call for the same month means the spread can never be worth more than $1,000 ñ the difference between the two strike prices.
Risk 1 to make 7Ö
Bobís spread is an out-of-the-money (OTM) call spread because both strikes are higher than the stock price of 126.64.
If the stock does rise, Bob could conceivably make $874 ñ the $1,000 the spread might be worth minus the $126 he paid for the spread, which is his maximum risk.
So Bob is risking $126 to make $874, roughly the same as ìrisking 1 to make 7.î
Öor risk 8 to make 2?
As for me, I was thinking about another call spread: Buy the 110 call for $1,850 and sell the 120 call for a $1,045 credit for a net cost of $805.
This is an example of an in-the-money (ITM) call spread because both strikes are lower than the current price of the stock.
So Iíd be paying $805 on a spread that canít be worth more than $1,000. My maximum net profit would just under $200 ñ so Iíd be risking 8 to make 2.
I know what you might be thinking thatís a fairly poor risk/reward profile. You might even have a point.
But would it change your mind if I pointed out that unless the stock price changes, time decay works against Bobís position while it works in favor of mine?
Theta: Headwind or tailwind
Hereís the theoretical value of these two call spreads at various times until expiration. The purple arrow shows the price of the stock when the trade is established.
Note how Bobís OTM call spread seems to lose value if the stock doesnít rise. He needs to see the stock move up ñ the sooner the better. My position, however, gains value even if the stock just drifts around its current price.
The chart also shows that at least in theory, if Amazon falls, even fairly late in the expiration cycle, I could conceivably close my position for a loss of perhaps $300. Thereís no guarantee, of course, but that would turn my trade into more of a ìrisk 3 to make 2î scenario.
This difference in time decay is because ITM and OTM call spreads each have different levels of theta.
Theta is the option Greek that measures the theoretical impact of time decay on an option position. If youíre long an option with a theta of -0.025, for example, in theory (all other things being equal), the position will lose $2.50 per day from time decay. If youíre short the option, you theoretically gain $2.50 per day.
Theta does change based on time and stock movement. Hereís another chart that shows the ITM and OTM call spreads along with the theoretical theta of these positions at various stock prices.
Good theta vs. bad theta
Why would these option spreads have different time decay patterns?
By definition, any bull call spread means being long one option, where theta works against you and short another, where theta works with you. But each spread offers different amounts of each.
Hereís a chart that shows the theta of these options at the time the spread is first established. With the OTM call spread, the bad theta (in red) outweighs the good theta (in green) providing negative net theta (in yellow). The ITM spread has an opposite profile.
An even better choice: A bull put spread
Iíve compared these two spreads to demonstrate how the strike prices you select impacts the theta of your position. But I probably wouldnít consider the 110/120 ITM call spread just to take advantage of theta.
Thatís because thereís a better choice, at least in my opinion.
You see, for almost any bull call spread, thereís an equal and opposite bull put spread you can establish that offers a similar risk/reward ratio. So letís look at those option prices again, this time showing the puts and the calls.
Instead of risking $805 for the 110/120 bull call spread with a maximum profit of $195, I could switch these strikes over to the put side.
By selling the 120 put for $400 and buying the 110 put for $191, Iíd collect a credit of $209. This is an example of an OTM bull put spread.
This provides basically the same deal at the ITM bull call spread. If all goes well and the stock stays above 120, I keep the $209 net credit I received. If all doesnít go well, the 110 put I bought caps my loss at $791 (the difference between the $1,000 Iíd have to pay to buy back the spread less the $209 I collected).
The theoretical profit chart shows that these two positions are virtually identical. Although not shown on the chart, they do have similar time decay properties.
But the put spread does offer a couple of advantages.
First, the out-of-the-money puts tend to have much narrower bid/ask spreads than the in-the-money calls. Second, if all goes well, Iíd have to pay another set of commissions to close the call spread, but with the put spread I could just let both options expire worthless and keep the credit I collected.
I should point out that a bull put spread like this requires keeping $1,000 in margin available, but thatís not much different than paying $805 for the bull call spread (and in fairness, Bobís OTM call spread costs far less and the position requires no margin).
Key takeaways? Regardless of your view on the movement of a stock, you can have theta working for you or against you. And with spreads like these, the options market usually offers equivalent risk/reward profiles whether you use calls or puts.
The Greeks represent the consensus of the marketplace as to the how the option will react to changes in certain variables associated with the pricing of an option contract. There is no guarantee that these forecasts will be correct.
While Theta represents the consensus of the marketplace as to the amount a theoretical optionís price will change for a corresponding one-unit (day) change in the days to expiration of the option contract there is no guarantee that this forecast will be correct.
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