Parity Option Trades Revisited

Notice in these examples…the Bull Put Credit Spreads and Bull Call Debit Spreads are using the same strike prices; as are the Bear Call Credit Spreads and Bear Put Debit Spreads. This is because these combinations are “parity trades”.

BULL PUT CREDIT SPREADS EXAMPLE:

• Stock XYZ is trading at $40.
• Your sentiment is Bullish.
• You would sell the 35 put for $0.80.
• This obligates you to buy shares of stock at $35 if the stock is trading below $35.
• You would buy an 30 put for protection, for $0.15.
• This gives you the right to put the stock to someone if it is trading below $30.
• Total net credit (potential profit) is $0.65 ($0.80 – $0.15).
• Max risk is $4.35. (Difference in Strike Prices minus the net credit).

Expiration Scenarios:

• If the stock stays above $35, both options expire worthless and you keep the entire $0.65 net credit.
• If the stock goes below $35 but stays above $30, you are obligated to either buy shares of stock at $35 or buy to close the option for its intrinsic value.
• If you let the stock go below $30 without taking action, I will accrue the maximum loss of $4.35.
• The stock will be put to me at $35, and I can sell it at $30.
• I keep the initial $0.65, but I lost $5.00 at assignment, making my loss $4.35.

BEAR CALL CREDIT SPREADS EXAMPLE:

• Stock XYZ is still trading at $40.
• Your sentiment is Bearish.
• Sell the 45 call for $1.00.
• This obligates you to deliver shares of stock at $45 if the stock is trading above that price.
• You would then the 50 call for $0.25.
• This allows you to buy shares of stock at $50.
• Total net credit (potential profit) is $0.75 ($1.00 – $0.25).
• The max risk is $4.25 (Difference in strike prices minus the Net Credit).

Expiration Scenarios:

• If the stock stays below $45, both options expire worthless and you keep the net credit.
• If the stock goes above $45 but stays below $50, you are obligated to either buy shares of stock at the market price and deliver them at $45, or buy to close the option for its intrinsic value.
• If you let the stock go above $50, you can buy shares of stock at $50, but you are obligated to sell them at $45.
• This will give you a 5-point loss, but you still keep the initial $0.75.

The goal of both spreads is to have the options remain OTM (out-of-the-money) so they expire worthless and you keep the net credit. The margin required for these strategies is the max risk, i.e. the difference in strike prices minus the net credit.
For the bull put credit spreads example, the margin would be $4.35. So, you would have to have $4.35 times the number of contracts times 100 in your account to cover the spread. For 1 contract, you would need $435. For 10 contracts, you would need $4,350 in your account to make the trade.

BULL CALL DEBIT SPREADS EXAMPLE:

• Stock is still at $40.
• You are Bullish.
• You would sell the $35 call for $6.10.
• This obligates you to deliver shares of stock at $35 if the stock is trading above $35 at expiration.
• You would buy the August $30 call for $10.40.
• This gives you the right to buy shares of stock at $30.
• Your total debit (payment) into the position is $4.30 (Ask – bid).
• The Debit is your maximum risk.
• You do not need to have any money in my account to cover the trade, since you are only risking the net debit.
• The total profit that can be earned is the difference in strike prices (5) minus the net debit ($4.30) = $0.70.
• In order to obtain this profit, the stock has to be trading above the highest call strike price ($35).
• You can then liquidate both options and earn the 5-point difference in strike prices, which will give you the $0.70 profit over the debit.

Expiration Scenarios:

• If the stock is trading above $35, you can buy to close the 35 call and sell to close the 30 call.
• This will give you the 5 points of intrinsic value.
• You could also exercise the 30 option and buy shares of stock at 30, then sell them at $35.
• This would also give you the 5-point difference.
• If the stock is trading below $35 but above $30, the short option will expire worthless and you could sell to close the long option for its remaining value.
• You would suffer a loss, but it would not be the max loss.
• Example: The stock expires at $32. The 35 option expires worthless and you can sell to close the 30 option for $2.00 (intrinsic value). This will give you a loss of $2.30, since you paid $4.30 to get into the position and only received $2.00 back.
• If you let the stock fall below $30, both options will expire worthless and you will have accrued the maximum loss = the Net Debit = $4.30.

BEAR PUT DEBIT SPREADS EXAMPLE:

• Stock is still at $40.
• You are Bearish.
• You could sell the $45 put for $5.85.
• This obligates you to buy shares of stock at $45 if the stock is trading above that at expiration.
• You could buy the $50 put for $10.15.
• This gives you the right to put the stock to someone at $50.
• Your total net debit (payment) into the position is $4.30 (Ask – bid).
• The Debit is your maximum risk. You do not need to have any money in my account to cover the trade, since you are only risking the net debit.
• The total profit that can be earned is the difference in strike prices (5) minus the net debit ($4.30) = $0.70.
• In order to obtain this profit, the stock has to be trading below the lower strike price (45).
• You could then liquidate both options and receive the 5-point difference in strike prices, which will give you the $0.70 profit over the initial $4.30 debit.

Expiration Scenarios:

• If the stock is trading below $45, you could buy to close the $45 put and sell to close the deeper ITM $40 put.
• This will give you 5 points of intrinsic value, and a profit of $0.70.
• If the stock is trading above $45 but below $50, your 45 put would expire worthless and you would sell to close the $50 put for any value you could get.
• This would give you some loss, but not the maximum loss.
• If you let the stock go above $50, you will accrue the maximum loss.
• Both options will expire worthless and you will lose the entire net debit.

PARITY:
Notice in these examples…the Bull Put Credit Spreads and Bull Call Debit Spreads are using the same strike prices; as are the Bear Call Credit Spreads and Bear Put Debit Spreads. This is because these combinations are “parity trades”.

In both cases, you want the stock to stay above 35 (the short strike price) to obtain the full profit. Now, although the risk is comparable and the profit seems higher on the BULL CALL DEBIT SPREAD, remember that you have to actively close the debit spread at expiration (liquidate) to obtain the profit. A successful Debit spread will cost you 4 options transactions (2 to open, 2 to close) where a successful credit spread only cost you 2 options costs since you want the options to expire worthless. In this Parity scenario, you would have to decide if the extra $0.05 of potential profit would cover the extra 2 commission costs.

In this scenario, we see that the credit spread is offering a higher potential profit over the debit spread. Comparing the two scenarios, we might make a better deal and save commission costs trading the Credit Spread over the Debit Spread.

[tags]Bull Call Debit Spreads, Bear Call Credit Spreads, Bear Put Debit Spreads, Bull Put Credit Spreads[/tags]