Understanding What Drives Option Spreads

09/12/2012 6:00 am EST

Focus: OPTIONS

Tyler Craig of TylersTrading.com explains how weekly and monthly option spreads can converge and diverge, and the reasons behind the moves.

Given the plethora of strike prices across the variety of expiration months, option traders face a bevy of choices when structuring a position. The options market is a world of tradeoffs lacking a single solution for all participants. Risk and reward exist on a correlated scale where a rise in one invariably results in lifting the other.

With this backdrop in mind, let’s tackle a recent question I recently received via e-mail regarding bull put spreads: "I’ve noticed that there are times when a weekly spread can be the same price as a monthly spread or a front month spread can be the same as second month spread. I feel sure that there is a trade there somewhere but I’m not sure...any thoughts?”

Rather than being a rare phenomenon, the situation in question arises on a daily basis in virtually all optionable securities. If, of course, the bull put spread is structured with strike prices close to the current stock price (at-the-money in other words). Here’s an example on Apple (AAPL) when it was trading around $675.

  • Sep 675-670 put spread @ $2.42

  • Oct 675-670 put spread @ $2.42

  • Nov 675-670 put spread @ $2.50

  • Dec 675-670 put spread @ $2.50

As you can see, the price of each put vertical spread is clustered around $2.45 regardless of the amount of time to expiration. The essence of the question is not just why the pricing is so consistent, but also what opportunities, if any, arise from such a situation.

The underlying reason behind the linked pricing of the aforementioned at-the-money vertical spreads has to do with probability. In order to capture the maximum profit on the 670-675 bull put spreads outlined previously, AAPL has to sit above $675 by expiration.

With AAPL having recently resided above $675, it’s fair to say there is a 50-50 chance it could sit above or below $675 at any point in the future. Because the September spread has just as good of a probability of producing a profit as the December spread, they are priced with a similar risk-reward proposition.

Now, if we were comparing the price of out-of-the-money bull put spreads, the pricing from one month to the next would differ substantially. The addition of each month of time would increase the amount of reward available in the spread, like so:

  • Sep 645-640 @ $.92

  • Oct 645-640 @ $1.52

  • Nov 645-640 @ $1.87

  • Dec 645-640 @ $1.97

With the spreads positioned out-of-the-money, time is now a decisive factor influencing the probability of profit. With AAPL trading at $675, there is a much higher probability of it remaining above $645 for the next two weeks than for the next three months. Since the September put spread boasts a higher probability of profit, it delivers a smaller reward.

The key takeaway here is that risk, reward, and probability are all inextricably linked in the options arena. A change in one of the variables will undoubtedly change the others.

Tyler Craig is a trader and blogger at TylersTrading.com.

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