Let’s take a bull call spread as our starting point. The S&P 500® (SPX) is at 1213 and the mid-point between the bid and the ask is 59.00 for the November 1210 call, and 48.30 for the 1230 call. A bull call spread consists in purchasing the call with the lower strike, the 1210 at 59.00, and in writing the call with the higher strike, the 1230 at 48.30. Since the purchased option is trading at a higher price than the written option, the spread is established for a debit, 10.70 in our example.
What is the risk and profit potential of this strategy? The risk is simply the initial net debit. If at option expiration SPX is trading below 1210, both call options will expire worthless and the spread go off the board with no value. The loss is then 10.70. This spread’s maximum profit will be realized if, at expiration, SPX is trading at or above 1230. In this case, the spread’s value will be 20 points (for example, with SPX at 1235, the long call would be worth 25, the short call 5, for a net value of 20), leaving us with a profit of 9. 30 - the spread’s final value of 20, less the 10. 70 cost.
An alternative to the above call spread, is a bull put spread. In order to compare apples to apples, the bull put spread must have the same expiration date and the same strike prices. So our bull put spread consists of writing the higher strike put, the 1230 at 64.50, and purchasing the lower strike put, the 1210 at 54.50. This spread is established for a net credit since the written option is trading at a higher price than the purchased one – 10 points in this example. The put spread’s maximum profit will be realized if, at expiration, SPX is above 1230. Both put options would then expire worthless and the initial credit would become the profit on the trade. The risk of the put spread is if SPX drops below 1210, in which case the spread would have to be covered at a cost of 20 points. Since this position was established for a credit of 10, closing it out for a 20 debit leaves us with a 10 point loss.
Notice the parallels: both spreads produce their maximum gain if SPX is 1230 or higher; both spreads result in their maximum loss if SPX is 1210 or lower; the maximum profits and losses are quite similar, their difference probably the result of bid-ask spreads in the 4 options traded. So which spread, debit or credit, should a trader favor?
The only argument in favor of the credit spread is that the trade does not require a cash outlay (although margin, equal to the spread’s maximum value must be posted) and in fact generates funds which can be invested until the spread is unwound or expires. More about this later. Also, note that SPX options are European-style and that early exercise or assignment is not an issue with either spread.