May 4, 2011: We can see from the table below that we can purchase the SPX 1335-1340 call spread for a $3.65 debit, and sell the OEX 595-600 call spread at $3.85 for a net 20¢ credit. This allows us to be bullish the market with the long SPX call spread while being protected with the short OEX call spread. If the market falls dramatically and both spreads expire worthless, we at least keep the 20¢ credit.
May 19, 2011: We fast forward until the day prior to expiration and see that the market didn’t move higher as we had anticipated. Instead, it sold off a tad. This is the downside to a long stock, long call, long call spread or short put position. Yet, the 1-5 spread was protected. We now can sell the long SPX spread out at $4.20 and buy back the short OEX spread for $2.10.
"Tale of the tape" (below) shows that we made money on both the SPX and OEX sides of the trade. Had we been bullish on the market and elected to get long an OEX call spread, we would have lost money. Instead we were bullish and decided to get long a derivative of the indexes as protection. We made 55¢ on the SPX side of the trade and we made $1.75 on the OEX side of the trade for a total of a $2.30 per-share profit. This is an example of why a carefully thought out and placed 1-5 spread can be a strong tool in your trading arsenal.
Susan Steward is chief economist for RandomWalkTrading.com.
Click here for a brief historical plotting of the SPX, OEX and 1-5 spread.