Debate: Buy Puts or Sell Call Spreads?

05/23/2011 3:00 pm EST

Focus: OPTIONS

Joe Kinahan

Chief Market Strategist, TD Ameritrade

Option traders might be better off selling a call spread instead of buying a put when they think a stock is going to decline, says Joe Kinahan of thinkorswim.

If I have an idea about the direction of a stock, should I buy a call or sell a put? Our guest today is Joe Kinahan, here to talk about that. 

Joe, so let’s say I think a stock is going to go down. Should I buy a put on it or should I sell a call on it?  Which option strategy should I take?

Well, there is no perfect answer to that, as we both know, unfortunately. 

However, I prefer to sell call spreads—not the individual option—rather than just buy a put. I would sell an out-of-the-money, just-out-of-the-money call spread. 

The reason being I can still be a little bit wrong if it’s out of the money and make money because it allows the stock to go up a little bit. 

The other reason is I have a higher probability, because, over time, as we know, options start to decay. 

If I buy the put and the stock sits there or just goes down a little bit, I could actually be right directionally if it went down and lose money, and it’s happened to too many people. It’s actually really upsetting when I see it happen to people. 

If I sell the call spread, I could actually be a little wrong. Maybe the stock goes up just a little bit. As an example, say I followed a stock, and I’m just throwing this out, not a recommendation, General Electric (GE), trading around $21.80 [At the time of interview – Editor].   

Maybe I’d sell the $22-$23 call spread. It could go up to $22. I could be wrong a little bit…still make money. Whereas, if I bought that $21 put, we have to go down 80 cents, plus the premium I paid, so I could actually lose money in the long run. 

We see it so many times where people are like “I can’t believe it. I was right and lost money.” The decay factor in options is very heavy, something people always have to be aware of.

And that spread, talk about that. Are we talking about buying calls at the same month or one month out?

So, a vertical spread, thank you. That’s a great question.

I would sell the same month, sell the one closer to the money, and buy one further out of the money, maybe $1 wide, $2 wide, whatever risks you’re willing to take for the premium you receive up front.

But with that, at least you’re defining your risk. Just selling a call, you have undefined risk, so that might not be the best idea. 

The nice thing about defining risk is you always know worst-case scenario, and if you do a call vertical spread or a put vertical spread, it’s not meant for stop orders. 

You essentially already put in a stop. You know worst-case scenario right up front. You know where you can get out. It really helps you be a lot easier about the trade and the time factor gives you a chance to make money.

And if I own that underlying, how can a spread help me maybe make a little more money or protect my risk there?

Well, if I own the underlying, that’s the one time I might think about just selling the call and sit, let it get called away, taking that premium. But if it was just a straight shot, so to speak, I didn’t have any stock, buying put versus selling call, I’d do the call spread. 

If I owned the underlying, I would probably think about selling that just-out-of-the-money call, taking the premium, and I have a little bit off of that effort on the downside. If I really think it’s going to go down, why wouldn’t I get out of some of my stock?

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