Bull Spread – Understanding Options for a Bull & Bear Market Part 5
Bull Spread – Understanding Options for a Bull & Bear Market (Part 5)
We covered the out rights, the buys, calls, and puts. We did the verticals, the two-sided spread. So now let’s add another piece and look at the three ways. First, the bullish side. We’ve done our analysis. We looked at the market and we think stocks going higher. We’ve covered these different choices of things you can do you can buy the shares if you’re really aggressive and you want to go all in and buying the shares, you can do that. You can buy calls you can buy a bull call spread we covered that, we can sell a bull put spread, all these different things you can do.
Let’s turn this into a three-way and actually combine both of them. The call purchased and the bull put spread, and let’s walk through what that looks like and why we would do it. Here’s our example, the three sides. Buying four of the $110 calls, and we’re just picking prices off of here and getting execution prices that are close to the values we retrieve that our calculator, so buying for of the $110 calls for $4.30. Selling four of the 100 puts and buying for the $80 puts and doing that spread for a four dollar and $80 cent credit. That leaves us with a net credit of 50 cents to do this whole three-way.
Now, A and B is going to is going to compare. The driving force behind the traders are bullish and we want the upside potential to gain with big moves to the upside. Significant moves higher we want to capitalize on it. Buying calls is the comparison trade and paying seventeen twenty-two by four of the one ten calls. Or do the three-way and receive an upfront credit of 200 dollars. You’d probably see right away, we’ve done a very important thing here. We’ve taken away the theta risk, entirely. When you buy an option and the stocks not moving your way or it starts to trickle in your direction or maybe trickle the other way. The painful part is seeing time decay working against you and every day the option value losing money through time decay.
We’ve eliminated that here, and that’s a big benefit to doing a three-way. However, there’s also a big cost to that, whenever you compare options strategies, there’s a benefit and there’s a cost. So, we’ll look at that on the next slide when we put up the p&l graphs here. We have the comparison now, buying four of the $110 calls for $4.30. That’s one trade we might do and we’re going to look at that here and the three-way is all done for a 50 Cent credit and that’s going to be the right side. So, we have our stock prices at expiration, if it sells off and goes in the other direction that we’re expecting by a large amount, then this does not work out too well for the three way. You can see how much more you’re risking as a loss as compared to just buying the calls. You buy the calls you’re risking what you paid upfront. When you do this three way, you are virtually risking the difference or the spread between your put strikes. That’s assuming your net cost is around zero. Your risk is going to be the difference here.
In this case, it’s significant. It’s a 20-point different. So, we’re risking 20 points. We did this for a half a dollar credit. So, 19 and a half points is what we’re risking overall. And if you do the math there, 19 and a half points times a hundred times four that $7,800. So, a lot larger risk. That’s the downside and it’s a much more significant capital requirement then buying calls out right. This is a significant negative for doing a three-way. One of the positives, and there significant as well. If the stock is right around here $100, $105, $110, our calls expire worthless. We lose all of it. 1,720 is decayed by the time we’ve reached expiration down to nothing. Whereas the three way, we had this credit if everything expires out of the money if the stock is in at $105 and look at these strike prices, everything’s out of the money.
Now we just keep the credit received. We’ve taken that Theta risk completely out of it. And if we’re correct on our directional outlook, we’ve actually increased the profits and I’m going to throw out the p&l graph in a second. But we’ve increased the profits here because we have more Delta’s. Not only do we buy a call option, that’s long Delta, we sold a put option and bought a lower strike put. So, that is also long Delta the put spread side of things.
We sold this spread and enhanced our returns if the stock rally. So, those are the two benefits. Take Theta out of the equation and if the stock rallies and it goes the way we expect it to do we have enhanced gain because we actually combined two bullish strategies. We didn’t say double up, but we added two strategies together. For those two significant benefits, we accept a much larger potential loss.
It looks really interesting when you put it on a graph and here is buying for of the $110 calls for four dollars and thirty cents. You see what that looks like, that break-even point on the upside is $114.30 and let’s put up the three way that we were able to do. Again, for a 50 cent credit in this case that puts our break-even point a whole heck of a lot lower than that. If the $100 put that we sold goes in the money by 50 Cents, then we’ve given back the 50 cent credit. So that break-even point down there is at 99 half. That’s far lower than buying the outright call is and that’s because we’ve taken the Theta decay out of the equation. Now, we do have a pretty big spread here and you’ll notice on the downside just how much of a difference the risk is.
I did that by design. You certainly might look at a higher strike put or changing the strikes a bit when you do that to be more conservative. You’re probably going to change this and flip it from a from a credit to a slight debit, but not take as much risk. 20 points why? You know, it’ll be up to you. How confident are you in the trade? How far out are you going? Do you really think the potential for a massive move in the opposite direction that you’re expecting is likely? How likely is it? And then choose the appropriate width in between the strikes. Looking at it here, we chose strikes that virtually did this three-way spread for break even and you can clearly see the benefit. The break-even point is so much lower than going long calls on the upside.
We always outperform the long call to the upside, and we get all of that exposure. Stock rallies $120, $130, $140, we have all this exposure to the upside to keep making money. We have a call option that can keep gaining value, and we didn’t pay for that. We don’t have Theta risk, two huge positives and we accept this much greater potential law. So, it’s an interesting way to combine a couple of strategies and be bullish.