Mitch Crask introduces the reader to the switch spread trade in Options Strategies for Sophisticated Traders (Traders Press, 2005). In essence, it turns “a debit spread or straddle into a credit position by switching some or all of the long options in debit spreads to single stock futures.” (p. 2) Why go through this exercise? Why not just put on a credit spread using only options? Crask points to three essential differences between options and single stock futures that make the switch trade preferable. First, the price of the single stock future is not directly related to the volatility of the underlying stock. Second, the single stock future does not experience time decay. And third, most single stock futures at fair value have a delta at or very close to 1.00.
Early on Crask walks the reader through a simple bull switch credit spread using a July 2003 closing price for eBay. Step 1: Buy the September 105 call for a debit of $7.60; sell the September 110 call for a credit of $4.80, for a net debit of $2.80. Step 2: Buy the September single stock future for $108.28 minus the eBay close of $108.14, for a premium loss of $0.14. Step 3: Sell the September 110 call for $4.80. Now you have a net credit of $4.66. What have you accomplished? You lowered the breakeven point from $107.80 to $103.62. And whereas the maximum gain you could have realized on the debit spread was $2.20, you now have a maximum potential gain of $6.38 on the switch spread (strike of short call minus the cost basis of the single stock future). On the downside, you have increased your risk profile. Whereas the maximum loss was $2.80 on the option spread, the switch spread has for all intents and purposes unlimited risk since the single stock future can fall all the way to zero. Crask suggests that the trader of the switch spread place his stop at the point of maximum loss on the initial option spread. In this case, the reward/risk ratio of the switch spread is 2.28 compared to 0.79 for the option spread.
In this book Crask analyzes switch strategies for the most popular option spread trades, including verticals, calendars, straddles and strangles, butterflies and condors, and box spreads. For those option traders who love to dissect positions and think about the myriad ways to structure trades, Crask offers an interesting alternative.
One disadvantage of the switch spread trade is that it requires the trader to pony up more money. The margin for single stock futures is 20%. The other potential disadvantage, and here I’m not on sure ground, is that there may be liquidity issues with single stock futures. They never really took off as a stand-alone product, and I’m not sure how much volume there is in the EFP (exchange for physicals) market. I checked the OneChicago site for SSF volume, and it seemed anemic. But even if the precise trade Crask recommends isn’t practical, it should get those little grey cells in options traders’ brains working.