Many traders who are new to trading options prefer to keep it simple, usually sticking to straight buying of puts or calls to match their market outlook. But moving from outright options buying and selling to spread trading is not as difficult as it may seem. Here we look at a trade that can be used for trading a bullish outlook with a limited risk options credit spread, which can be substituted for buying options. The position contains a significant statistical edge, as well as an overall lower risk profile.

Trading the QQQQ
To illustrate the above strategy, we will use the QQQQ (formerly the QQQ) as an example. The "Qs", as they are commonly known, represent the ticker symbol for the Nasdaq-100 Trust, an ETF (exchange-traded fund) that tracks the Nasdaq 100 index. Traders can buy and sell the Qs if they want to trade the underlying Nasdaq 100 Index, much like futures traders trade futures contracts on the same index. Option traders, meanwhile, can trade the options on the QQQQ, and these options have exploded in volume since they were introduced. (For further reading on ETFs, see Introduction To Exchange-Traded Funds.)

Let's say you believe that you have a medium-term bullish outlook on the market and would like to speculate on this view using options. One approach might be to simply buy two long-dated at-the-money options on the QQQQ, which would have a position delta of about 100 (or 1.00).

Suppose you decide you would like to buy two January 2006 at-the-money options to go long on the QQQQ. This would give you unlimited upside profit potential with limited risk on the downside. The QQQQ at the time of writing was trading at 39.10, with the at-the-money January calls selling for 1.60. Therefore, you would need to pay $320 ($160 each) for the two options. So, the maximum risk is $320 should the QQQQ trade lower, with upside breakeven at 40.60. Figure 1 presents the profit/loss profile of this trade.

OF_TradingQQQQ_1.GIF Figure 1 - January 2006 at-the-money QQQQ 39 long calls.

Of course, one of the downsides to buying options is risk from time-value decay. This position would have a theta of $1.60 (measured here as a dollar value decline per day in the options value due to time decay) at the outset. Meanwhile, if the move never occurs, and the QQQQ heads lower, the loss of the entire premium paid for the options is possible. (To learn more about time value, see The Importance Of Time Value.)

Finding a Better Trading Solution
In order to speculate on a bullish move higher, it would be nice to minimize the theta risk mentioned above. Fortunately, there is a way to do this without sacrificing your probability of profit from a statistical point of view. There is only one small, insignificant cost, which comes in the form of a few extra dollars in commissions (because you are going to use a spread, which has an extra leg).

OF_TradingQQQQ_2.GIF Figure 2 - T+0 P&L, in-the-money January 2006 QQQQ 46 x 39 put spread.

Assuming again that the QQQQ is at 39.10, you would look toward puts to set up your bullish options spread. Here you would pick a deep in-the-money put to sell and an at-the-money put to buy. Figure 2 shows the profit/loss chart for this trade, and the legs of this in-the-money put spread are presented in Figure 3. You are selling the Jan 46 and buying the Jan 39 put for a credit of $570 per spread (your maximum profit). You are selling two spreads to make the position roughly equivalent to the long calls position shown above. As presented in Figure 3, there is only 1.30 in time value (.10 + 1.20 = 1.30) at risk for each option, or a total for both of $260 (1.30 x $100 x 2 = $260). This is the potential maximum loss if the market heads straight down, or remains below the 39 by expiration.

January
QQQQ Puts
Option Position Option Prices Time Value Net Credit
Jan 46 put Sell 2 6.90 0.10 --
Jan 39 put Buy 2 1.20 1.20 +$1,140

Figure 3 - In-the-money January 2006 QQQQ put spread.

Now as you can see in Figures 1 and 2, both positions are nearly equivalent in terms of position deltas (with the long calls gaining an edge if the QQQQ moves significantly higher), but the theta risk is significantly different. Looking below the profit/loss plots, you will find a table of data with the so-called "Greeks" for these different positions. (For further reading, see Using The Greeks To Understand Options.)

Note that the position theta is considerably less for your in-the-money put spread ($1.16 vs. $1.60). This means that the straight at-the-money calls position is losing $.44 cents more per day in time value.

OF_TradingQQQQ_3.GIF Figure 4 - Expiration P&L, January 2006 in-the-money QQQQ put spread.

While the vega risk profiles are similar, the maximum loss potential should the market head lower for the straight calls position is $320 (as seen in the at-expiration profit/loss chart in Figure 5). Meanwhile, in Figure 4, the maximum loss can be seen at $260 for our alternative bullish in-the-money put spread strategy.

OF_TradingQQQQ_4.GIF Figure 5 - Expiration P&L, January 2006 at-the-money QQQQ 39 call spread.

Finally, while not shown here, the probability of profit and expected profit are substantially different from a purely statistical point of view.

The probability of profit is just 37% with an expected return of -$1.00 for the long calls. Compare this with 41% probability of profit with an expected gain of $71 and you can see that there definitely is an edge over straight call buying using an in-the-money put spread. While, statistically, these trades don't look good overall, if your market outlook is correct and a good move higher occurs, you would be better off with the alternative approach based on this probability perspective.

Aside from a few dollars more in commissions because of the extra legs using the in-the-money put spread (none of these calculations include commissions), the only added "cost" here is that the upside profit potential is capped at $1,140 with the put spread. With a really big move higher, the long calls would acquire more potential profit at expiration.

The Bottom Line
Given the evidence, it seems that selling an in-the-money put spread on the QQQQ, which could be applied to many individual stocks, has certain key advantages over buying at-the-money calls. Not only is there a statistical (probability) edge, but time-value decay risk is considerably higher for the long calls position (38% per day more decay at the point of entry). Perhaps most importantly, the cost of being wrong is also higher, for the long calls. Maximum risk was shown to be 28% higher in the case of the outright calls position.

So if you are new to trading options, keeping it simple may mean short changing yourself. Consider moving to options spread trades, such as an in-the-money put spread - understanding them may be easier than you expected. (If you're looking for an introduction to the world of options, see our Options Basics Tutorial.)

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