Tuesday, 9 February 2016

SELLING PUTS VS. BUYING CALLS

The bullish trader has a variety of strategies that can be adopted. Buying calls or selling put spreads are two of the most popular choices.
Let's look at the choices for the typical bullish option trader. The market is rising and he wants to makes some money from that rally. Not having a specific stock in mind, he decides to trade index options and chooses SPY, an ETF (exchange traded fund) that mimics the performance of the S&P 500 Index.
Using live data, it is Jun 12, 2014, 9:15 am CT. 
SPX is priced at 194.62.
Let's assume that we prefer options for which expiration Friday is Jul 18, 2014.

Our trader has a few possible choices. Keep in mind that most newer option traders prefer to buy out-of-the-money (OTM) options because they cost less than in-the-money options. More experienced traders understand that buying OTM options is a losing strategy over the longer term, but rookie traders have not yet reached that level of sophistication.
An at-the-money call option, the SPY Jul 18 ‘14 195 calls option costs $1.82, or $182 per contract.
Partial list of OTM options, and their premium (cost to buy):

·         SPY Jul 18 '14 196 call; $1.32

·         SPY Jul 18 '14 197 call; $0.98 

·         SPY Jul 18 '14 198 call; $0.68

Partial list of OTM put spreads and the premium available from selling them:

·         SPY Jul 18 '14 193/194 put spread; $0.39

·         SPY Jul 18 '14 192/193; put spread  $0.33

·         SPY Jul 18 '14 189/190 put spread; $0.20
Although there are other choices, let's assume that your choice is limited to these.
Call buyers, especially buyers of out-of-the-money calls must see the index price increase before they have any chance to earn a profit. That increase must come before the options expire, and the sooner the better.
In addition, for those traders who buy and hold options until they expire, the price increase must be large enough to overcome the premium and the out-of-the-money amount.
For example, when paying $0.98 for the 197 call and holding to expiration, the break-even point is $197.98. That represents a significant rally from the current $194.62 price.
And all that is required just to break even.
I do not like the idea of buying OTM calls. However, the main benefit of doing so is that there is the possibility of earning a very large profit because there is no theoretical limit on how far the index can rally and thus, no theoretical limit of the possible profit.
Put spread sellers have no chance for a big payday. In return for that limitation, their trades come with three advantages: a high probability of earning money; limited losses; and best of all -- there is no need for the stock )or index) to rally. If SPY never moves higher than its current price, the trader still earns the entire cash premium when SPY doesn't decline by very much during its lifetime. Imagine making a bullish trade, seeing your prediction fail to come true, and still earning a profit. That is why selling a limited number of put spreads works better than buying call options, especially over the longer term.
For example, selling the 132/133 put spread can return a profit of up to $33 (if both options expire worthless) when the maximum possible loss is $67. That is a very reasonable risk/reward ratio -- especially when you are bullish and SPY must decline by $2.62 points before that max loss is reached.
Each trader must choose the strategy that feels best because having confidence in your trading methods gives you a psychological edge. In my opinion, the winning trader looks for the strategy that will help produce profits over the longer-term. Choosing a strategy that allows for a rare but large profit is for the gambler.

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