The price of options flexibility

Options are sometimes praised for their flexibility—the ability to potentially profit regardless of which way the underlying stock moves, for example—but such observations often fail to account for the limitations and risks that come with that “advantage,” or what it looks like to balance risk and reward in the real world.

Last Thursday, for example, apparel company PVH (PVH) was wrapping up its second week of consolidating after pulling back roughly 14% from a nearly one-year high:

For the sake of argument, let’s say an options trader thought the stock would break out of its range in the next couple of weeks. The most basic trades would be to buy an at-the-money (ATM) call for an upside breakout, or buy an ATM put for a downside breakout. At 11:55 a.m. ET on Thursday when PVH was trading around $79.40, a March $80 call (the ATM strike price) cost roughly 2.87 ($287), while a March $80 put was priced around 3.45 ($345).

Whatever their drawbacks (most prominently, time decay), basic long-options positions have defined risk—the price paid for them. Some traders, however, combine options in spreads to create positions that are less expensive, can potentially profit from up or down moves in the stock, or both. Here’s how a few well-known options spreads compared to the PVH long-call or long-put positions in terms of price on Thursday, and how they differed in terms of risk and potential reward:¹

1. March $80-$90 ATM bull call spread (long $80 call, short $90 call).
Cost (risk) relative to long call: 88%.
Trade-off: Potential profit capped at the upper (short) strike price.

2. March $80-$70 ATM bear put spread (long $80 put, short $70 put).
Cost (risk) relative to long put: 81%.
Trade-off: Potential profit capped at the lower (short) strike price.

3. March $80 long (ATM) straddle (long $80 call, long $80 put).
Cost (risk) relative to long call or put: 220% or 183%, respectively.
Trade-off: Ability to profit on up or down move comes with a potentially high price tag.

The call and put vertical spreads can be combined to create a three-legged strategy that, like the long straddle, has the potential to profit regardless of which way the underlying stock moves:

As the chart shows, this spread—usually referred to as an iron butterfly—has limited profit potential regardless of how much the stock rallies or falls (like the vertical spreads), but also has a lower cost (and thus, lower risk) than the straddle:

4. March $80-$90 iron butterfly (long $80 call, long $80 put, short $90 call, short $70 put).
Cost (risk) relative to long straddle: 84%.
Trade-off: Potential profit capped at the upper and lower (short) strike prices.

Whether the “discounts” in some of these spread positions are worth what they sacrifice in terms of potential profitability will depend on whether they complement a trader’s market outlook and risk-tolerance level. Also, keep in mind these examples are a snapshot of a single stock at one moment in time. But knowing what you may be giving up in return for lower risk or more flexibility can help traders choose the most appropriate options strategy for a given situation.

Today’s numbers include (all times ET): Advance International Trade in Goods (8:30 a.m.), Retail Inventories (8:30 a.m.), Advance Wholesale Inventories (8:30 a.m.), S&P Case-Shiller Home Price Index (9 a.m.), FHFA House Price Index (9 a.m.), Chicago PMI (9:45 a.m.), Consumer Confidence (10 a.m.).

Today’s earnings include: Agilent Technologies (A), AutoZone (AZO), Blink Charging (BLNK), Duolingo (DUOL), First Solar (FSLR), HP (HPQ), Rivian (RIVN), Ross Stores (ROST), Urban Outfitters (URBN), Verisk Analytics (VRSK).

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¹ Prices reflect the midpoint of each option’s bid-ask range.