Spreads can stretch the brain in directions it doesn’t really want to go for many Series 7 candidates. Of course, we’ve already discussed how some people view this stretching as a pleasurable activity, so let’s focus on the other 95% who would rather pound bamboo chutes under their fingernails than decipher a debit call spread.
First, what the heck is a “spread”? A spread is simply the purchase of one option and the sale of another. Rather than selling an ABC Aug 50 call by itself, which would leave the writer exposed to unlimited loss, the investor also purchases an ABC Aug 60 call. He’ll collect more writing the Aug 50 call than he’ll spend on the Aug 60 call, so we call it a “credit spread” or a “credit call spread.” Of course, what I just wrote baffles and annoys most candidates–they don’t see any premiums attached, so how can I just, like, know that the Aug 50 call is worth more? Because an ABC Aug 50 call is a contract giving someone the right to buy ABC common stock at 50, which is better than the right to buy the stock at 60. For intrinsic value, think from the buyer’s perspective. A “call” lets someone buy stock–they want to buy low, so the lower the call’s strike price, the more valuable it is. Once you can see that the Aug 50 call is worth more than the Aug 60 call, you just have to remember that if the individual buys the Aug 50 and sells the Aug 60, he’ll start out with a debit–why? He had to have paid more for the Aug 50 call than he received selling the Aug 60 call. So, we call it a “debit spread.”
To profit, a credit spread needs to “narrow” or “expire.” A debit spread investor wants and needs the spread to “widen” or for the options to be “exercised.”
So, is the following a debit or a credit spread:
Buy 1 ABC Jan 50 call
Sell 1 ABC Jan 45 call
- Which option is worth more? The right to buy the stock for $45 or for $50? The ABC Jan 45 call is worth more than the ABC Jan 50 call
- Did the investor buy or sell that option? The investor sold the more valuable option.
- Therefore, this is a credit spread
What about this one:
Buy 1 ABC Jan 50 put
Sell 1 ABC Jan 45 put
- Which option is worth more? The right to sell stock for $50 or for $45? The right to sell stock for $50 is more valuable.
- Did the investor buy or sell that option? The investor bought that option.
- Therefore, this is a debit spread
I know, I know. Many of you friggin’ hate this stuff more than you friggin’ hate reading the instructions that came with your I-POD. That’s normal. Unfortunately, the Series 7 is anything but, so keep grinding it out with these spreads. And feel free to submit your questions through the comments field.