(In case you're just joining: so far in this series we've defined long call spreads, talked about time's effects on the position, and explored delta and volatility.)

Now, here's a new way to think about spreads: they approximate synthetic collars pretty accurately, although there are a few key differences worth noting. First, we'll set up each position, then check out how their P&L graphs are basically identical and list key differences.

Let's set up a new long call spread, for a net debit of -2.60:

Buy 1 VLO 62.50 May Call @ -4.40
Sell 1 VLO 67.50 May Call @ +1.80

As we discussed in previous weeks, we've lowered our possible delta for the total position, creating a lower delta than just buying the call alone since each leg is "pointing" in the opposite market direction. This also has a somewhat neutralizing effect against a drop in implied volatility, as well as time decay.

Now consider the following collar. If you're not familiar with collars, they consist of a long stock position,  protected by a combination of buying an OTM put and selling an OTM call. The put protects against a downside move that could hurt the long stock position, while selling the call helps underwrite the cost of buying that put.

Buy 100 VLO shares @ - 65.00
Buy 1 VLO May 62.50 Put @ -1.50
Sell 1 VLO May 67.50 Call @ +1.80

The P&L graphs for each below look quite similar, but with a slight difference. The difference is the break-even point or where they cross the X-axis. The break-even for the call spread is 62.50 strike plus the debit paid, 2.60 (4.40 - 1.80) or 65.10. The break-even on the collar is the debit paid for the stock, 65, less the credit received, .30 (1.80 - 1.50) or 64.70.

This might lead you to think the collar is a better trade to do because you have a lower break-even -- a common mistake for new option traders. Fact is, the cost or break-even is essentially the same when you consider the big picture. Collars typically require much more capital upfront because you're actually trading the stock. The cost to carry the stock position until options expiration of the options is around 40 cents, the difference in the break-evens is .40 (65.10 - 64.70). This has to be the case, or there would be an arbitrage opportunity. 

In short, both of these trades have basically the same profit and loss parameters. So if you like the concept of only trading options, you might want to consider long call spreads as an alternative to the collar strategy.

Next week's post focuses on long put spreads.

Regards,

Brian (OG)

Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.

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