What Are we Trying to Achieve When Trading? Part 2

To truly get an accurate picture of a comparison between the likelihood of success for two different strategies, we must use a real life example, and compare ‘apples to apples’. We are going to do that here with two strategies: That is, we will compare selling ‘at the money’ Put options (spreads) with buying ‘at the money’ Call options, and using the Actual Risk on both.

We will use a real trade and real company for this example, but we have changed the company code, the ‘ticker’, to XYZ.

XYZ closed at $28 even, so we’ll use this to give us an accurate comparison between the two strategies. The figures used are the overnight Indicative Margin Prices for Options (fair value) provided by the ASX.

Example A - Selling Put Spreads

Jenny thinks the share price of XYZ is going to go up, and decides to sell ‘at-the-money’ Credit Put Spreads. It’s the start of the month, and she sells the $28 put and buys the $27 put (a $1 spread) and receives a premium of 37.5c, or $375 per contract.

This means the Actual Risk is 62.5c per share, or $625 per contract of 1,000 shares ($1 per share minus the premium of 37.5c). No matter what happens to the price of XYZ, the most Jenny can lose is 62.5c per share, or $625 per contract.

Jenny has $10,000 to invest, so she is able to sell 16 contracts, and receives a net premium of $6,000.

As long as the share price is above $28 by the end of April, Jenny will receive 100% of her net premium, being $6,000.

The ‘break even’ point – where Jenny doesn’t lose any money, but also doesn’t make any money – is $27.625 (the exercise price of $28 less the premium received of 37.5c).

Jenny loses all her money ($10,000) if the price finishes below $27 at expiry (her bought put level).

Example B - Buying Call Options

John also thinks the share price of XYZ is going up, but instead he decides to buy at-the-money Call Options.

The price of the $28 call option is 94c. John also has the same amount of money to invest, that is, $10,000.

With this $10,000 he can buy 10 contracts, which means his Actual Risk is $9,400.

For John to realise the same profit as Jenny – $6,000 – the share price must be $29.54 at expiry. Why? It’s the exercise price of $28, plus the cost of buying the put (94c), plus the $6,000 profit which is another 60c per share.

For John to break even, the share price must be $28.94.

The point at which John loses all his money is if XYZ is $28 or below at expiry.

Let’s compare the two on a ‘like for like’ basis…

JohnJennyDifference
InvestmentBuy 10 Contracts of Calls at $28Sell 16 Contracts of $28/$27 Spread

Minimum Price needed to earn $6,000 profit
$29.54$28$1.54

Price at break even point
$28.94$27.625$1.315

Price at which lose 100% of investment
$28$27$1

As you can see, John needs a much higher share price than Jenny does to be as successful.

• Jenny makes 100% of her profit at a share price $1.54 lower than John
• Jenny breaks even with a share price $1.31 less than John, and
• The price has to drop by $1 more for Jenny to lose all her investment.

The question we ask ourselves is this – Which do we think is more likely?

a) XYZ finishes above $28 by end April, or…
b) XYZ finishes above $29.54 by end April.

To me, this is a pretty easy choice! There is a much greater chance it will be above $28 than above $29.54.

I know Jenny will be successful considerably more often selling Put Spreads than John will be buying call options, because she have such a larger margin of error, and doesn’t need the share price to move at all. With call options, the share price MUST move significantly just to break even!

Having said that, the call option strategy will yield a considerably higher profit if XYZ goes well above $29.54, since the profits for Selling Insurance is capped. That’s the trade off – even though Jenny’s spread trade is more likely to be successful, the maximum profits are fixed. John’s bought call is much less likely to be successful, but if it is, his profits are unlimited.

This example is a rise of 5.5% in under a month. Again, I ask myself – which do I think is easier to achieve: a) picking a stock that doesn’t need to go up at all, or b) picking a stock that needs to increase by more than 5.5% in a few weeks?

I don’t think anyone can argue with the fact the former is considerably easier and will be achieved much more regularly.

The example above is a ‘like for like’ basis, with the same exercise price (exactly at the money) for both examples, and is really the only way to get a true comparison.

However, in the real world we would probably not do these exact trades. Let’s compare a couple that is more ‘real’…

Example A – Selling Put Spreads (2)

Jenny still thinks XYZ will go up in price, but decides to sell her spreads at a lower price to build in a bit of a ‘buffer’, namely $27 with $26.50 protection. For this she receives a net premium of 16c per share, or $160 per contract.

Her Actual Risk per share is now 34c, or $340 per contract. If she has $10,000 to invest, she now sell 29 contracts. She will therefore receive $4,640 in total premiums.

The minimum price Jenny needs to realise 100% of her profit is $27 even.

Her break even point is $26.84, and the point at which she loses all her investment is anything under $26.50.

Example B – Buying Call Options (2)

John thinks XYZ will go up in price, and decides to buy call options at $28.50, and pays 72c per option, or $720 per contract. With $10,000 he can buy 14 contracts, and therefore spends $10,080.

To earn the same as Jenny – $4,640 – John needs the price to go up to $29.45. Why? It’s the $28.50 exercise price, plus the 72c cost of buying each put he needs to make back, plus 33c per share (14 contracts at $330 = $4620) to equal Jenny’s profit.

To break even, John needs the price to go up to $29.12.

And the price that John loses all his investment is $28.50

Let’s compare the two now…

JohnJennyDifference
InvestmentBuy 14 Contracts of Calls at $28.50Sell 29 Contracts of $27/$26.50 Spread

Minimum Price needed to earn $4,640 profit
$29.45$27$2.45

Price at break even point
$29.12$26.84$2.28

Price at which lose 100% of investment
$28.50$26.50$2

John now needs the share price to go up over a whopping $2 more than Jenny does to achieve the same results!

•Jenny makes 100% of her profit at a share price $2.45 lower than John!
•Jenny breaks even with a share price $2.28 less than John!
•The price has to drop by $2 more for Jenny to lose all her investment!

Who do you think is going to get it correct more often and make money more regularly?

I certainly know who I’d be betting on...