Fun With Options: Amplifying Returns With Spreads
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This is the fifth article in my Fun with Options Series:
Today, I will discuss how to Amplify returns using Option Spreads.
What is a Spread?
A Spread is simply when you buy and sell two different options simultaneously. For our purposes, we will stick to the following 4 spreads. These spreads have a specific name: Vertical Spreads.
With Vertical Spreads, you know your risk-reward up front.
They can be a powerful low-cost way to amplify returns.
1) Buying Call Spreads:
If you buy calls with one strike price, and then sell calls with a higher strike price, then you are buying a call spread. Note: The number of calls bought should equal the number of calls sold. Example: Buy MSFT $180 calls and simultaneously sell $185 calls, both expiring on the same date.
2) Selling Call Spreads:
If you sell calls with one strike price, and then buy calls with a higher strike price, then you are selling a call spread. Again, the number of calls sold should equal the number of calls bought. Example: Sell MSFT $180 calls and simultaneously buy $185 calls, both expiring on the same date.
3) Buying Put Spreads:
If you buy puts with one strike price, and then sell puts with a lower strike price, then you are buying a put spread. Again, the number of puts bought should equal the number of puts sold. Example: Buy MSFT $180 puts and simultaneously sell $175 puts, both expiring on the same date.
4) Selling Put Spreads:
If you sell puts with one strike price, and then buy calls with a lower strike price, then you are selling a put spread. Again, the number of puts sold should equal the number of puts bought. Example: Sell MSFT $180 puts and simultaneously buy $175 puts, both expiring on the same date.
Let’s see what would happen in the following cases:
Buying/Selling a Call Spread
Buying/Selling a Put Spread
Case 1: Buying/Selling a Call Spread
Let’s assume we do this with one 150 Strike MSFT Call AND one 155 Strike MSFT Call. Based on prices at the time of writing,
The $150 Calls cost $10.55 per option
The $155 Calls cost for $6.65 per option
If you Bought the Call spread, it will cost $3.90 per spread, or $390. Therefore, if you Sold the Call spread, you would instead receive $390 per spread.
What is the Risk Reward?
Notice how, with spreads the risk-reward is known upfront.
The buyer and seller have opposite risk-rewards.
The buyer is risking $390 in order to make $110.
The seller on the other hand is risking $110 in order to make $390.
That’s a massive difference - the buyer is risking almost 4X the amount the seller is risking.
Clearly, the buyer has significantly higher odds of being right, or at least that’s what the market believes.
A few observations:
Notice how the profits and losses are opposite for the spread buyer vs the spread seller. This is to be expected since they are on opposite sides of the transaction.
If the call spread is in the money (i.e the stock price is higher than the higher strike call), then the spread will be worth the difference in strike prices (this is $5 in the above example).
If the spread is out the money (i.e the stock price is lower than the lower strike call), then the spread will be worthless.
If the stock price is in between the two strikes, then the higher-strike call will be worthless. The lower strike call will be worth the stock price minus the lower strike price.
Case 2: Buying/Selling a Put Spread - Disney: A Real World Example
The Disney trade I discussed back in November 2019 represents the exact same strategy as the one above, except with Puts instead of Calls. I had sold the January 15 2021 $135 Puts and bought the January 15 2021 $130 Puts. See here for details.
Notice how you can create a similar risk-reward scenario using Calls or Puts.
What is the Risk Reward?
As the seller of the spread, I risked $2.4 in order to make $2.6 per spread.
If right, I stand to make 108% ($260/$240).
Again, this trade is risky because you can lose all your money if the stock is below $130 in Jan 2021. That said, in order to make 108% the stock simply needed to go up from $130.75 to $135 at the time of purchase, a mere ~3% in ~14 months! That’s the Tradeoff.
When Should We use Spreads vs Calls to Amplify Returns?
Only you can answer that. There are several tradeoffs. It really depends on what you think will happen. You can create spreads with various strike prices to generate various different return expectations. It then becomes a game of probabilities.
That said, if you buy a spread, the capital needed is much lower than if you buy calls outright. But then again, with spreads, the upside is also limited.
When volatility is high, Calls can be expensive. That’s another time when Spreads may be a better choice.
Another major advantage of spreads is that you can significantly amplify returns with minimal or even no movement in the stock (by expiration). We can already begin to see this happening, in the table below.
For the sake of discussion, let’s assume the DIS trade involved buying 100 shares of DIS stock for $13,075. One could have used all the money to purchase the stock or some of the money to sell Put spreads instead, thereby applying the amplification strategy. See table below.
With a ~10% move in the stock so far, ~2% leverage gives us a 30% amplification boost. Not bad!
If we were closer to the expiration date today, that amplification would be significantly higher. The time value remaining in the spread would be worth almost $0 instead of the current ~$1.70, and we would have captured all of that difference. As a result, the amplification would be around 90% instead of 30%.
When I bought Disney stock in November 2019, I decided to use both amplification strategies together (Buying calls and selling Put spreads). The call enabled me to capture more upside if the stock moved higher quickly. The spread allowed me to buy time for the stock to move up, even if it did so slowly, just in case the Disney Plus launch hadn’t been as successful as it has been. One can argue that buying 14 months of time is way more than was necessary. Sure, you may be right. Creating a similar spread that expired say 3 or 6 months in the future instead of 14 months could have been another approach. It just has different tradeoffs.
As I said, it’s a game of tradeoffs.
Fun With Options: The Conclusion
At the beginning of this “Fun with Options” series, I claimed that options are a powerful, low-risk, low-capital and leveraged way to speculate. Now that you understand options better, I hope this has become apparent.
Options require low-capital because the amount of money needed to buy options is significantly smaller than the amount of money needed to buy an equivalent amount of stock.
If you’re right about your directional bet, within the option expiry window, the leverage works in your favor and can generate outsized returns.
In many cases, your maximum risk can be known up front. You can manage this risk by position sizing.
We have only scratched the surface here but as you can see, options are a great addition to any investor’s investment tool belt.