Parity Trading – Option Spreads

In a recent blog article we mentioned some option trading rules of thumb (June 1: Options Trading – Tips of the Trade). Tip #6 outlined the concept of the parity trade. Every options strategy has a parity trade that may be a better value.

6. If you are trading vertical spreads remember that for each credit spread, there is a parity debit spread trade that will act much the same if your prediction is right. Usually, one of these trades will be mis-priced and offer an advantage over the other. Check the parity trade before you open a position. Also consider if an iron condor trade might be appropriate as well.

For example, let’s say that stock XYZ is trading at $74.90. After analyzing the chart you feel that XYZ will continue to go up and has a support level around $72. This situation may be a candidate for a Bull Put Credit spread:

Sell 10 70 strike puts for $2.50.
Buy 10 65 strike puts for $1.35.

Total Net Credit = $1.15
(Max Profit if the stock stays above 70 at expiration).

Margin Requirement = $3.85
(Difference in Strike Prices – Net Credit).

% Return = 29.8%
(Net Credit / Margin).

As long as XYZ stays above $70, both put options will expire worthless and you will keep the net credit. Although this is a great trade for a 30-45 day time period, we might not want to enter the Bull Put Credit spread without first checking XYZ’s corresponding Bull Call Debit spread:

Buy 10 65 strike calls for $10.90.
Sell 10 70 strike calls for $7.10.

Total Net Debit = -$3.80.
(Max Loss if XYZ drops below 65 at expiration)

Margin Requirement = Net Debit.

% Return = 31.6%
(Difference in Strike Price – Net Debit / Net Debit)

If XYZ closed above $70, we could close both options for their intrinsic value. This would give us a $5 credit and a total profit of $1.20. In this case, the parity Bull Call Debit spread would yield the investor a slightly higher return over the Bull Put Credit spread. However, an investor has to keep commission costs in mind. Although this Bull Call Debit spread has a slightly higher return, the position has to be liquidated in order to obtain the full return. The Debit spread will have four transactions (2 to open, 2 to close) where the Credit spread will only have two transactions if the trade is successful.This type of parity analysis also works for Bear Call Credit spreads. Before placing the trade, an investor should compare the risk-reward ratios of the corresponding Bear Put Debit spread.

Going back to the first analysis, if you analyzed XYZ and saw strong support at $72 and resistance at $83, you might consider trading an Iron Condor instead of just trading the Bull Put Credit spread or the corresponding Bull Call Debit spread. The Iron Condor trade is a neutral strategy combining a Bull-Put Credit vertical spread and a Bear Call Credit vertical spread:

Buy 10 65 strike puts for $1.35.
Sell 10 70 strike puts for $2.50.
Sell 10 85 strike calls for $1.75.
Buy 10 90 strike calls for $0.90.

Total net credit = $2.05
($1.20 for the Bull-Put and $0.85 for the Bear-Call).

Margin Requirement = $2.95
(Difference in Strikes from the wider spread – Net Credit)

% Return = 69.5%
(% return is realized if the stock is trading above $70 and below $85 at expiration).

If XYZ stays above the short put strike and below the short call strike at expiration, all four options will expire worthless and you will keep the entire net credit. Most online options brokers will only require margin on one side of the spread or the other. This means that you are collecting a larger net credit compared to the Bull Put Credit spread but you are only risking the same margin amount. If you are analyzing a stock and feel that it will remain within a certain trading range, an Iron Condor trade may maximize your returns compared to a single vertical credit spread.

Here is a short list of parity trades:

[tags]Parity Trading,Option Spreads, Bull Put Credit Spread, Bull Call Debit Spread, Bear Call Credit Spread, Bear Put Debit Spread, Iron Condor[/tags]