THE OPTIONS COURSE
BID-ASK SPREAD: A CLOSER LOOK
From the first moment we are exposed to a real options quote, we realize that options do not trade at just one price. There is a bid price and an ask (or offer) price. For example, the Cisco (CSCO) October 20 calls do not trade for 55 cents. Instead, you may see a quote similar to this: CSCO 22.50 Calls: .50–.60. In this example of the CSCO 22.50 calls, $.50 is the bid and $.60 is the ask (or offer). That means that everyone who is interested in selling CSCO 22.50 calls can do so at $.50 and all interested buyers of CSCO 22.50 calls can own them for $.60. Since we are not market makers, in order to guarantee ourselves a fill, we must pay the ask and sell the bid.
To illustrate the meaning of these two prices, imagine walking into a car dealership. A dealer has two prices on a car. There is a dealer invoice and a sticker price. A car dealer is willing to buy cars for dealer invoice, and is happy when they’re sold at sticker price. Unless the dealer is trying to pad the sales numbers to meet some quota, we will not be lucky enough to drive a car off a lot for dealer invoice. However, in buying cars as well as in trading options, we try our best not to pay sticker price. Of course, this means the dealer can refuse to sell us the car, just as a market maker can refuse to trade with us. Only by paying the full no-haggle price can we be assured a fill on a trade.
In trading options, the reality is that while the quoted best ask in CSCO 22.50 calls may read $.60, someone in the CSCO pit may be willing to sell those calls for less. A car dealer may be willing to sell you a car for less than sticker price, but why pass on the chance that you or someone else might pay full fare? So the ask price will remain $.60 until someone tests it—namely with a limit order between the two amounts that define the bid/ask spread. A limit order is an order to buy or sell a financial instrument (stock, option, etc.) at or below a specified price. For instance, you could tell a broker to “Buy me one January XYZ call at $8 or less” or “Sell 100 shares of XYZ at $20 or better.”
I bring up the example of CSCO because of the incredible liquidity in that stock. That liquidity in the stock and in its corresponding options allows the bid-ask spread to be very tight—10 cents wide, in this case. So the question then arises: Is there anything that keeps the market makers from creating wider spreads? In the case of less liquid stocks, is there a chance that spreads can become too wide? Is there anything to protect us from abusively wide spreads? Actually, there is! It may not seem like it at times, but there exist legal width limits for options. This practice was instituted by the exchanges to keep the market makers in check and to entice retail customers to trade more.
These limits are based on the option price—the higher the price of the option, the higher the allowable width of the bid-ask spread. One small note: For option prices $3 and up, options no longer trade in nickels. The smallest denomination for those options is dimes. So do not try to pay $3.65 for an option. We must make up our mind to make our purchase price either $3.60 or $3.70. A pet peeve of many market makers is a retail customer who does not know this information. Now let’s look at a practical application of legal widths and how they can affect us. Let us revisit those same CSCO October 22.50 calls with a bid-ask of .50–.60.
TABLE Option Values and Limits
If we decide to be aggressive and pay the ask, we are incurring 10 cents of slippage (the difference between the bid price and the ask price). Now let’s say we were right and CSCO shoots up $5; our calls are now worth somewhere around $5.50! As we look to exit our trade, we may look forward to a market quote of 5.40–5.60. However, the limit on the width of those options is 50 cents. Hence the real quote facing us may be closer to 5.20–5.70. Fifty cents of slippage is quite possible. We may console ourselves with the fact that we made some money in our trade, but that’s no excuse for giving up so much on our exit. We can usually diminish the problem by testing the market and placing limit orders inside of the bid-ask spread.
STRATEGY ROAD MAPS
For your convenience, the following subsections provide step-by-step analyses of the vertical spreads.
Bull Call Spread Road Map
In order to place a bull call spread, the following guidelines should be observed:
1. Look for a bullish market where you anticipate a modest increase in the price of the underlying stock.
2. Check to see if this stock has options available.
3. Review call options premiums per expiration dates and strike prices. Bull call spreads are best placed on stocks that have at least 60 days until expiration. The utilization of LEAPS options is a good choice for this strategy. LEAPS give you the opportunity to put time on your side.
4. Investigate implied volatility values to see if the options are overpriced or undervalued.
5. Explore past price trends and liquidity by reviewing price and volume charts over the past year.
6. Choose a lower strike call to buy and a higher strike call to sell. Both options must have the same expiration date. In general, a good combination is relatively low “buy” strikes combined with higher “sell” strikes. Get the breakeven low enough so that you can sleep at night. The lower buy strikes lower the breakeven point. Give yourself plenty of room to profit if the stock runs. This is accomplished by choosing higher sell strikes.
7. Determine the specific trade you want to place by calculating:
• Limited Risk: The most that can be lost is the net debit of the two options.
• Unlimited Reward: Calculated by subtracting the net debit from the difference in strike prices times 100.
• Breakeven: Calculated by adding the lower strike price to the net debit.
• Return on Investment: Reward/risk ratio.
8. Create a risk profile for the trade to graphically determine the trade’s feasibility. The risk profile for a bull call spread visually reveals the strategy’s limited risk and profit parameters. Notice how the maximum profit occurs at the short call strike price.
9. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
10. Create an exit strategy before you place the trade.
• Consider doing two contracts at once. Try to exit half the trade when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk, allowing it to accumulate a bigger profit.
• If you have only one contract, exit the remainder of the trade when it is worth 80 percent of the maximum possible value of the spread. The reason for this rule is that it usually takes a very long time to see the last 20 percent of value in a profitable vertical spread. It’s better to take the trade off and look for new trades where the money can be put to better use. We recommend exiting the trade prior to 30 days before expiration.
11. Contact your broker to buy and sell the chosen call options. Place the trade as a limit order so that you limit the net debit of the trade.
12. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock closes below the breakeven point.
13. Choose an exit strategy based on the price movement of the underlying stock:
• The underlying stock rises above the short strike: The short call is assigned and you are obligated to deliver 100 shares (per call) to the option holder at the short strike price. Exercise the long call to buy the underlying stock at the lower strike and deliver these shares to the option holder. The resulting profit is the maximum profit available.
• The underlying stock rises above the breakeven, but not as high as the short strike: Sell a call with the long call strike and buy a call with the short strike. There should be a small profit remaining.
• The underlying stock remains below the breakeven, but above the long strike: Offset the options by selling a call with the long strike and buying a call with the short strike to partially mitigate the initial debit or allow you to pocket a small profit; or wait until expiration and sell the long call to offset the trade’s net debit and let the short option expire worthless.
• The underlying stock falls below the long option: Let the options expire worthless, or sell the long call prior to expiration to mitigate some of the loss.
Bear Put Spread Road Map
In order to place a bear put spread, the following guidelines should be observed:
1. Look for a bearish market where you anticipate a modest decrease in the price of the underlying stock.
2. Check to see if this stock has options available.
3. Review put options premiums per expiration dates and strike prices. Buy options with at least 60 days until expiration.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. These spreads are best placed when volatility is low.
5. Explore past price trends and liquidity by reviewing price and volume charts over the past year. Look for chart patterns over the past one to three years to determine where you believe the stock should be by the date of expiration.
6. Choose a higher strike put to buy and a lower strike put to sell. Both options must have the same expiration date. Determine the specific trade you want to place by calculating:
• Limited Risk: The most that can be lost on the trade is the net debit of the two option premiums.
• Unlimited Reward: Calculated by subtracting the net debit from the difference in strike prices times 100.
• Breakeven: Calculated by subtracting the net debit (divided by 100) from the long strike price.
• Return on Investment: Reward/risk ratio.
7. Create a risk profile for the trade to graphically determine the trade’s feasibility. If the underlying stock increases or exceeds the price of the short put, the trade reaches its maximum risk (loss) potential. Conversely, if the price of the underlying stock decreases or falls below the strike price of the long put, the maximum reward is attained.
8. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
9. Make an exit plan before you place the trade.
• Consider doing two contracts at once. Try to exit half the trade when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk allowing it to accumulate a bigger profit. If the spread doubles, exit half of the position.
• If you have only one contract, exit the remainder of the trade when it is worth 80 percent of its maximum value.
• Exit the trade prior to 30 days before expiration.
10. Contact your broker to buy and sell the chosen put options. Place the trade as a limit order to limit the net debit of the trade.
11. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock rises above breakeven point.
12. Choose an exit strategy based on the price movement of the underlying stock.
• The underlying stock falls below the short strike: The short put is assigned and you are obligated to purchase 100 shares (per option) of the underlying stock from the option holder at the short put strike price. By exercising the long put, you can turn around and sell the shares received from the option holder at the higher long put strike and pocket the difference—the maximum profit available.
• The underlying stock falls below the breakeven, but not as low as the short strike: Sell a put with the long put strike and buy a put with the short strike. There should be a small profit
remaining.
• The underlying stock remains above the breakeven, but below the long strike: Sell a put with the long strike and buy a put with the short strike, which will partially offset the initial debit or allow you to pocket a small profit; or wait until expiration and sell the long put to offset the trade’s net debit and let the short option expire worthless.
• The underlying stock rises above the long option: Let the options expire worthless, or sell the long put prior to expiration to mitigate some of the loss.
Bull Put Spread Road Map
In order to place a bull put spread, the following guidelines should be observed:
1. Look for a bullish market where you anticipate a modest increase in the price of the underlying stock.
2. Check to see if this stock has options available.
3. Review put options premiums per expiration dates and strike prices. Look for combinations that produce high net credits. Since the maximum profit is limited to the net credit initially received, try to keep the net credit as high as possible to make the trade worthwhile.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for options with forward volatility skews—where the higher strike option you are selling has higher IV than the lower strike option you are purchasing.
5. Explore past price trends and liquidity by reviewing price and volume charts over the past year or two.
6. Choose a lower strike put to buy and a higher strike put to sell. Both options must have the same expiration date. Keep the short strike at-the-money. Try to avoid selling an in-the-money put because it is already in danger of assignment.
7. Place bull put spreads using options with 45 days or less until expiration. Since the profit on this strategy depends on the options expiring worthless, it is best to use options with 45 days or less until expiration to put time decay on your side.
8. Determine the specific trade you want to place by calculating:
• Limited Risk: The most you can lose is the difference between strikes minus the net credit received times 100.
• Limited Reward: The net credit received from placing the combination position.
• Breakeven: Calculated by subtracting the net credit from the short put strike price. Make sure the breakeven is within the underlying stock’s trading range.
• Return on Investment: Reward/risk ratio.
9. Create a risk profile for the trade to graphically determine the trade’s feasibility. The diagram will show a limited profit above the upside breakeven and a limited loss below the downside breakeven. In the best scenario, the underlying stock moves above the higher strike price by expiration and the short options expire worthless.
10. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
11. Make an exit plan before you place the trade.
• Consider doing two contracts at once. Try to exit half the trade when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk, allowing it to accumulate a bigger profit.
• If you have only one contract, exit the remainder of the trade when it is worth 80 percent of the maximum possible value of the spread. The reason for this rule is that it usually takes a very long time to see the last 20 percent of value in a profitable vertical spread. It’s better to take the trade off and look for new trades where the money can be put to better use.
12. Contact your broker to buy and sell the chosen put options. Place the trade as a limit order so that you maximize the net credit of the trade.
13. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock falls below the breakeven point.
14. Choose an exit strategy based on the price movement of the underlying stock:
• The underlying stock rises above the short strike: Options expire worthless and you keep the initial credit received (maximum profit).
• The underlying stock rises above the breakeven, but not as high as the short strike: The short put is assigned and you are then obligated to purchase 100 shares from the option holder of the underlying stock at the short strike price. You can either keep the shares in hopes of a reversal or sell them at the current price for a small loss, which is not completely balanced out by the initial credit received. To bring in additional money, sell the long put.
• The underlying stock remains below the breakeven, but above the long strike: The short put is assigned and you are then obligated to purchase 100 shares of the underlying stock from the option holder at the short strike price. You can either keep the shares in hopes of a reversal or sell them at the current price for a small loss, which is not completely balanced out by the initial credit received. To mitigate this loss, sell the long put.
• The underlying stock falls below the long option: The short put is assigned and you are then obligated to purchase 100 shares of the underlying stock from the option holder at the short strike price. By exercising the long put, you can sell these shares at the long strike price. This loss is partially mitigated by the initial credit received and results in the trade’s maximum loss.
Bear Call Spread Road Map
In order to place a bear call spread, the following guidelines should be observed:
1. Look for a moderately bearish market where you anticipate a modest decrease in the price of the underlying stock—not a large move.
2. Check to see if this stock has options.
3. Review call options premiums per expiration dates and strike prices. Look for combinations that produce high net credits. Since the maximum profit is limited to the net credit initially received, keep the net credit as high as possible to make the trade worthwhile.
4. Investigate implied volatility values to see if the options are overpriced or undervalued. Look for options with a reverse volatility skew—lower strike options have higher implied volatility and higher strike options have lower implied volatility.
5. Explore past price trends and liquidity by reviewing price and volume charts over the past year or two.
6. Choose a higher strike call to buy and a lower strike call to sell. Both options must have the same expiration date. Place bear call spreads using options with 45 days or less until expiration.
7. Determine the specific trade you want to place by calculating:
• Limited Risk: The most you can lose is the difference in strike prices minus the net credit times 100.
• Limited Reward: The maximum reward is the net credit received from placing the combination position.
• Breakeven: Lowest strike price plus net credit received
• Return on Investment: Reward/risk ratio.
8. Create a risk profile for the trade to graphically determine the trade’s feasibility. The risk graph of a bear call spread slants downward from left to right, displaying its bearish bias. If the underlying stock falls to or past the price of the short put, the trade reaches its maximum profit potential. Conversely, if the price of the underlying stock rises to or exceeds the strike price of the long put, the maximum limited loss occurs.
9. Write down the trade in your trader’s journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade.
10. Make an exit plan before you place the trade.
• Consider doing two contracts at once. Try to exit half the trade when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk, allowing it to accumulate a bigger profit.
• If you have only one contract, exit the remainder of the trade when it is worth 80 percent of its maximum value.
11. Contact your broker to buy and sell the chosen call options. Place the trade as a limit order so that you maximize the net credit of the trade.
12. Watch the market closely as it fluctuates. The profit on this strategy is limited—a loss occurs if the underlying stock rises above the breakeven point.
13. Choose an exit strategy based on the price movement of the underlying stock:
• The underlying stock falls below the short strike: Let the options expire worthless to make the maximum profit (the initial credit received).
• The underlying stock falls below the breakeven, but not as low as the short strike: The short call is assigned and you are then obligated to deliver 100 shares of the underlying stock to the option holder at the short strike by purchasing these shares at the current price. The loss is offset by the initial credit received. By selling the long call, you can bring in an additional small profit.
• The underlying stock remains above the breakeven, but be- low the long strike: The short call is assigned and you are then obligated to deliver 100 shares of the underlying stock to the option holder at the short strike price by purchasing these shares at the current price. This loss is mitigated by the initial credit received. Sell the long call for additional money to mitigate the loss.
• The underlying stock rises above the long option: The short call is assigned and you are then obligated to deliver 100 shares of the underlying stock to the option holder at the short strike. By exercising the long call, you can turn around and buy those shares at the long call strike price regardless of how high the underlying stock has risen. This limits your loss to the maximum of the trade. The loss is partially mitigated by the initial credit received on the trade.
CONCLUSION
The four vertical spreads—bull call spread, bear put spread, bull put spread, and bear call spread—are probably the most basic option strategies used in today’s markets. Since they offer limited risk and limited profit, close attention needs to be paid to the risk-to-reward ratio.
Never take the risk unless you know it’s worth it! Each of these strategies can be implemented in any market for a fraction of the cost of buying or selling the underlying instruments straight out. In general, vertical spreads combine long and short options with the same expiration date but different strike prices. Vertical trading criteria include the following steps:
1. Look for a market where you anticipate a moderately directional move up or down.
2. For debit spreads, buy and sell options with at least 60 days until expiration. For credit spreads, buy and sell options with less than 45 days until expiration.
3. No adjustments can be made to increase profits once the trade is placed.
4. Exit strategy: Look for 50 percent profit or get out before a 50 percent loss.
In general, volatility increases the chance of a vertical spread making a profit. By watching for an increase in volatility, you can locate trending directional markets. In addition, it can often be more profitable to have your options exercised if you’re in-the-money than simply exiting the trade. This isn’t something you really have any control over, but it is important to be aware of any technique for increasing your profits. These strategies can be applied in any market as long as you understand the advantage each strategy offers.
However, learning to assess markets and forecast future movement is essential to applying the right strategy. It’s the same as using the right tool for the right job; the right tool gets the job done efficiently and effectively. Each of the vertical spreads has its niche of advantage. Many times, price will be the deciding factor once you have discovered a directional trend. The best way to learn how these strategies react to market movement is to experience them by paper trading markets that seem promising. Once you have initiated a paper trade, follow it each day to learn how market forces affect these kinds of limited risk strategies.