How to Choose Among Equivalent Trades
Here's what should factor into your decision.
Minyan Jack writes:
I read through your blog and also did a simple analysis this morning. It shows clearly that the collar is equivalent to put credit spread as well as bull call spread.
In the option studies, I've found it's difficult to determine which to choose (put credit spread or bull call spread) when entering a trade.
One thing I considered is: If I would like to buy the stock at lower price, I'll go for put credit spread. Is that right?
Also, in spread, e.g. bull call spread, there are three types of options:
a) buy ITM call, sell ATM call
b) buy ITM call, sell OTM call
c) buy ATM call, sell OTM call
I've read several option books recently, and none of them have given me a clear guideline.
1. If you proved it to yourself that the collar is equivalent to selling a put spread or buying a call spread, why don't you believe the proof?
If the trades produce exactly the same financial results -- and that's one requirement for the positions to be equivalent -- why does it matter which you choose? It doesn't matter -- unless the markets are inefficient. That's a rare occurrence.
Unless you already own shares, avoid the three-legged collar and cut trading expenses by choosing a two-legged put spread.
Here's how to determine which to trade -- and this seldom applies, but is worth checking: Assume it's a five-point spread and that you can collect $2.10 when selling the put spread. If you can pay less than $2.90 for the call spread, then that's the spread of choice.
But, remember: Buying means you pay interest on that $290 instead of collecting interest on the $210. Thus, the call spread must not only be < $2.90, but enough less to compensate for the cost to carry the position.
2. "Buying the stock at a lower price" does NOT depend on the spread chosen. You wind up with a stock position only when expiration arrives and the stock is between the strike prices of the spread.
When you own the call spread, your long call is in the money and you exercise. You pay the lower strike price.
When you sell the put spread, your short put is in the money and you're assigned an exercise notice. You pay the higher strike price.
To compensate for paying the five-point higher strike price for the shares, you already collected the $500 difference when you sold the put spread instead of buying the call spread. Equivalence!
3. The selection of strike prices isn't something that can be easily described. When buying the call spread, you risk more, and can earn less when the options are in -- or at the money. In return, your chances of earning a profit increase.
My point: You can't just choose strikes based on whether option is at, in, or out of the money. Much more goes into the decision.
The term "bull" is redundant in "bull call spread."
When you buy a call spread, it's a bullish trade.
- When you sell a call spread, it's a bearish trade.
- When you sell a put spread, it's a bullish trade.
- When you buy a put spread, it's a bearish trade.
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