Hi! In Textbook Reading 15 Section 4.1.2, it was noted:
“Bull spreads with American puts have an additional risk, which is that the short put could be exercised early when the long put is not yet in the money.”
Can anyone help to explain what the risk is here? How would it differentiate from the case of European puts where the stock price ends up in between of two strike prices (i.e. short put ITM and long put OTM)?
Thanks a lot!
What is the challenge ? It’s really cakewalk to understand. An American is exercised anytime from 0 to T while the European is only exercised at T.
If the underlying within the timeframe is between two strikes (OTM and ITM), then it is obviously an additional risk as the short puts are immediately eligible for exercise while the long is not. But obvious you don’t face this issue with an European one.
Thanks for your help!
It follows that “If the bull spread uses American calls and the short call is exercised, the long call is deeper in the money, which offsets that risk… Thus, with American options, bull spreads with calls and bear spreads with puts are generally preferred but, of course, not required.”
It looks like moneyness of the long position plays a role…
Does it mean that, for bull put spread, I was obliged to buy something, with no compensation from the OTM long put, comparing to bull call spread where I can have positive value from the long call to compensate for the negative value from the short call, while the initial premium was out of our consideration here?
Does the preference over debit spread also hold true for European options at expiration when it ends up in between of two strike price?
I think you are confused with the perspective. In the case of Bull Call , your primary motive is to earn a BIG PAYOFF from the underlying’s movement. At lower strike the premium will skyrocket. So you just try to subsidise the same by selling a higher strike call. But obvious the short call will fetch you some premium so that your bet premium is somewhat reduced.
With Bull put your perspective is to COLLECT THE BEST ONE TIME PREMIUM. Hence you sell about from a HIGHER STRIKE. You just insure the same by buying a lower strike out.
With and American option if the underlying is in between the short put and the long put then the short put will trigger loss while the long put will not come to rescue.
It should be crystal clear once you draw a simple diagram.
You are welcome!
Why not simply sell the long puts?
Because it’s American style and because it’s double whammy and because it’s the insurance which you don’t sell.
Let’s look at some numbers.
Suppose that the spot price is $45/share and you build a 30-day bull put spread by:
You’re in the black $5.00.
Fifteen days later, the spot price is, say, $42/share, and the holder of the $50 strike put exercises it, so you lose $8 (= $50 − $42); you’re in the red $3.00.
You can sell your $40 strike put for $0.29, and you’ll be in the red only $2.71. Or you can hang onto it and hope that the price goes back up really fast.
If they’d been European options and the spot price at expiry was $42/share, you’d be in the red $3.00.
I’m not sure where the problem lies.
You can use other numbers, but the overall idea remains pretty much the same.
(Note: I used a BSM model for the option prices, so they’re really prices on European options, not American options. However, the relative prices won’t differ enough to change the conclusion.)
Sir,
For American options the BSM is not the ideal model. You may refer to the Black’s approximation. More apt. Secondly, you talked about 30 d option and 15 days down the line the Time Value erosion is not accounted in your calculation presented . I believe ( can’t recall 100%) the ITM has higher time value erosion than OTM.
Lastly… it is debated unless the underlying has an interim cash flow ( dividend , cpn) it is better to wait till expiry before exercising. However, I believe your quest may be solved should you refer to Black’s approximation instead of relying on BSM.
Which I already conceded. I used a model I had readily available.
I agree, but I believe that the differences will be negligible here.