Understanding Options Spreads

I wrote about the following options strategies for one of my clients, which is also posted on their web site. Basic strategies introduced here: http://bit.ly/SOjCU2

  1. Bull Put Spread
  2. Bull Call Spread
  3. Bear Put Spread

 

BULL PUT SPREAD

Limit your risk with the bull put spread
Capture profits from a rising stock while putting a limit on your losses.

Volatility in the market has calmed down from the heightened levels that we were experiencing in early fall. But the European debt crisis, higher oil prices, and other risks could renew the market’s uncertainty at any time. If volatility does come back, active investors may want to consider an options strategy called a bull put spread.

 

Why the bull put spread?
Picking the right stock, picking the right direction, and picking the right time to buy or sell can sometimes be difficult. This is why you may want to consider a bull put spread. A bull put spread offers limited risk, while giving you different ways to profit from volatility in the underlying asset. This strategy is particularly attractive for assets that are expected to rise slightly, may fall slightly, or may remain unchanged, and when volatility—the level of uncertainty in the market or a specific security—is high.

Establishing a bull put spread is relatively straightforward: sell one put option (short put) while simultaneously buying another put option (long put).

A bull put spread is also known as a vertical spread strategy (buying and selling options of the same underlying asset and expiration date) and a credit spread (you receive money at the outset of creating the position, and this is the maximum profit for the position). Because you are selling one put option and buying another, you are effectively hedging your position. The result is that potential gains and losses are capped.

 

When this strategy works
The bull put spread is used if you are moderately bullish on a stock or index, and your preference is to limit risk exposure. The primary goal is to make a short-term profit while limiting risk. You want the underlying asset (stock, index, etc.) to rise above both put options so they are out of the money(strike price is below the current market price), and the contracts expire worthless. If the options expire, you keep the credit you received.

 

What to look for before you initiate the trade
Before you initiate a bull put spread, it’s important to know what to look for. Here’s some helpful guidance:

Underlying asset—First, you need to identify an underlying stock, index, or other asset that you believe will rise moderately or will remain unchanged over a specific period of time.

Expiration date—Look at the option chain (the listing of put and call options, which shows strike prices, option premium, expiration date, etc.) for your chosen security, and choose an expiration date that matches your expected time frame. In certain circumstances, it may be advantageous to having a shorter time frame for a strategy like a bull put spread. This will most likely reduce the amount of premium (the price of the option) that you take in, but also reduces the possibility of an unforeseen event affecting the outcome of your trade. Make the appropriate selection based on your risk tolerances and investment expectations.

Strike price—Next, assess the various strike prices of the option you choose. For example, you might select strike prices with at least a 5-point difference (i.e., buy the 30 put and sell the 35, or buy the 80 put and sell the 85). Choose strike prices that match your forecast for the underlying security and that may thus allow you to earn the maximum profit potential.

Volatility—This is an important consideration. Think about whether you would prefer to initiate the bull put spread when volatility is relatively high (likely increasing both the amount of premium taken in and the risk associated with the trade) or when volatility is low (possibly reducing the premium taken in and the risk associated with the trade).

Another set of tools at your disposal when trading options are greeks (i.e., delta, gamma, theta, vega, and rho).* Using greeks can help you forecast how changes in price, time, and volatility can affect the value of your spreads.

Once your position is initiated, you should monitor it closely. Action may have to be taken before the contracts expire (we will soon discuss when and how this can be done). The goal is to have both legs (each side of the spread, the buy side and the sell side) expire worthless to earn the maximum profit potential.

 

Bull put trade, in action
Now that you have a basic idea of how this strategy works, let’s look at a few specific examples.

(Note: Before creating a spread, you must fill out an options agreement and be approved for a Level 3 options account. )

In April, you believe that XYZ stock, which is currently at $33 per share, will rise moderately over the next month or two to $35 per share or higher. You decide to initiate a bull put spread.

  1. You buy 1 XYZ May 30 put (long put) for $2.60, paying $260 ($2.60 x 100). Each options contract covers 100 shares, which is why you multiply the $2.60 premium by 100. At the same time, you sell 1 XYZ May 32 put (short put) for a limit price of $3.50, receiving $350 ($3.50 x 100). Our breakeven is $31.10 (highest strike price less the premium received). Notice in this example that the put we bought (long put) is out of the money and the put we sold (short put) is slightly out of the money. The stock could rise, remain unchanged, or fall slightly and still be profitable. Maximum profit: The credit received for this trade is $90 ($350–$260), less commission costs.
  2. Maximum risk: The maximum risk is the difference between the two strike prices, minus the credit you received. Therefore, maximum risk for this trade is $110 ($200–$90), plus commission costs.

Now, let’s look closely at what could hypothetically go right or wrong:

A winning trade: The underlying stock, XYZ, stays above the $32 strike price at the expiration date.

If the underlying stock stays above $32 at or before expiration, both puts remain out of the money and will expire worthless.

 

How to close this type of winning trade
You have a couple of options. First, you can close both legs of the trade. In the above example, if you enter a limit order, an order is placed to buy to close the short put for $90, and sell to close the long put for $40. Your profit is $40: $90 (your original credit) minus $50 ($90 for short put minus $40 for long put).

Second, if both options are out of the money, you can consider letting both legs expire worthless, achieving maximum profit. Depending on your specific risk and return objectives, you may want to consider closing both legs of the spread before expiration, once your profit goals are reached.

A losing trade: The underlying stock, XYZ, drops below the $32 strike price before the expiration date.

If the underlying stock drops below $30, and the option becomes in the money on or before expiration, both puts may rise in value. This is not what you expected or wanted. Your goal was to keep as much as possible of the $90 credit you originally received. However, as a trader, you should be prepared with a plan for exiting any strategy when things don’t quite go your way. Although the short put is costing you money, you are protected from the potentially substantial loss of that position by the long put. Nevertheless, in this scenario (both options are in the money), you can lose the maximum, or $110, if the stock drops below $30.

 

How to close a losing trade
It is worth looking at an example to see how you might close a losing trade like this. The short put might rise from $3.50 to $4.80, while the long put could rise from $2.60 to $3.20. Before expiration, you could close both legs. You would place an order to buy to close the short put for $480, and sell to close the long put for $320.

In this example, you must pay $160 to exit the position ($480 – $320), but you previously received a credit of $90. As a result, your total loss is a more manageable $70.

If you wait until expiration, you could lose the entire $110. Depending on your risk tolerance and objectives for the trade, you might choose to close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated.

Options traders should always be aware of early assignment, as well. There’s a chance you’ll be assigned early (before expiration) on the short put. Actively monitor your option positions and learn to manage risk.

 

Investing implications
Options trading strategies have unique risks and rewards. They offer more ways to take advantage of a given forecast. A bull put spread is a great example of the many option strategies that investors have at their disposal.

 

BULL CALL SPREAD

Options strategy: the bull call spread

A strategy designed to take advantage of price gains while potentially limiting risk.

Options traders looking to take advantage of a rising stock price while managing risk may want to consider a spread strategy: the bull call spread. This strategy involves buying one call option while simultaneously selling another. Let’s take a closer look.

Understanding the bull call spread: Although more complex than simply buying a call, the bull call spread can help minimize risk while setting specific price targets to meet your forecast.

Here’s how it works. 
First, you need a forecast. Say XYZ is trading at $60 per share. You are moderately bullish and believe the stock will rise to $65 over the next 30 days.

A bull call spread involves buying a lower strike call and selling a higher strike call:

Buy a lower strike call at $60. This gives you the right to buy stock at the strike price.

Then:

Sell a higher strike call at $65. This obligates you to sell the stock at the stock at the strike price.

Because you are buying one call option and selling another, you are “hedging” your position. You have the potential to make a profit as the share price rises, but you are giving up some profit potential—but also reducing your risk—by selling a call. Selling a call reduces the initial capital involved. The trade-off is you have to give up some upside potential. One advantage of the bull call spread is that you know your maximum profit and loss in advance.

How this strategy works Before you construct a bull call spread, it’s essential to understand how it works. Normally, you will use the bull call spread if you are moderately bullish on a stock or index. Your hope is that the underlying stock rises higher than your breakeven cost. Ideally, it would rise high enough so that both options in the spread are in the money at expiration; that is, the stock is above the strike price of both calls. When the stock rises above both strike prices you will realize the maximum profit potential of the spread.

As with any trading strategy it is extremely important to have a forecast. In reality, it is unlikely you will always achieve the maximum reward. Like any options strategy, it’s important to be flexible when things don’t always go as planned.

 

Before you initiate the trade: what to look for
Before you initiate a bull call spread, it’s important to have an idea of your criteria.

Underlying stock: First, you want to choose an underlying stock you believe will go up.

Expiration date: Choose an options expiration date that matches your expectation for the stock price.

Strike price: Choose offsetting strike prices that match your forecast For example, the stock is at $40. You believe it will rise to $45.

Volatility: Many traders will initiate the bull call spread when volatility is relatively high, which may reduce the cost of the spread.

Note: These are general guidelines and not absolute rules. Eventually, you will create your own guidelines.

 

Your first bull call trade
Before placing a spread, you must fill out an options agreement and be approved for spreads trading.

Now that you have a basic idea of how this strategy works, let’s look at more specific examples.

In June, you believe that XYZ, which is currently at $34 per share, will rise over the next three to four months to $40 per share or higher. You decide to initiate a bull call spread.

Options contracts: You buy 1 XYZ October 35 call (long call) at $3.40, paying $340 ($3.40 x 100 shares). At the same time, sell 1 XYZ October 40 call (short call) at $1.40, receiving $140 ($1.40 x 100 shares). Note: In this example, the strike prices of both the short call and long call are out of the money.

Cost: Your total cost, or debit, for this trade is $200 ($340 – $140) plus commissions.

Maximum gain: The maximum you can gain on this trade is $300. To determine your maximum reward, subtract the net debit ($3.40 – $1.40=$2 x 100 shares) from the difference in strike prices ($40 – $35=$5 x 100 shares). In this example, the maximum possible gain is $300 ($500 – $200).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $200.

Note: a bull call spread can be executed as a single trade. This is known as a multi-leg order.

Let’s take a look at what could go right, or wrong, with this strategy:

Example One: The underlying stock, XYZ, rises above the $35 strike price before the expiration date.

If the underlying stock rises above $35 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value, which is what you want. For example, the long call may rise from $3.40 to $5.10, while the short call may rise from $1.40 to $1.90. Note: Near expiration, as the long call option goes further in the money, the spread between the two call options widens, but it will not surpass the $5 maximum value.

 

How to close a winning trade
Before expiration, you close both legs of trade. In the above example, if you enter a limit order, you will buy back (buy to close) the short call for $190, and sell (sell to close) the long call for $510. That gives you a net sale of $320. You originally paid $200, leaving you with a net profit of $120. Important: remember that you can close both legs of the strategies as a multi-leg order.

Although some traders try to achieve maximum profit through assignment and exercise, if your profit target has been reached it may be best to close the bull call spread prior to expiration.

Example Two: The underlying stock, XYZ, drops below the $35 strike price before or near the expiration date.

If the underlying stock remains below $35 before expiration, both legs of the spread will drop in value due to time decay, which is not what you’d hoped to see. For example, the long call may fall from $3.40 to $1.55, while the short call may drop from $1.40 to $1.05.

To avoid complications, close both legs of a losing spread before expiration, especially when you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $200 investment.

 

How to close a losing trade
Before expiration, close both legs of the trade. Then you will buy back (buy to close) the short call for $105, and sell (sell to close) the long call for $155. In this example, your loss is $150: ($155 – $105) – $200 (your initial payment).

 

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short call. If this occurs, you may want to exercise the long call.

 

Other factors to consider
Trading spreads involves a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and other factors that affect an options price. This will help you understand how they can affect your trade decisions. You should also understand how commissions affect your trade decisions.

 

BEAR PUT SPREAD

Bear Put Spread: Profit from a falling stock price, while potentially limiting risk.

When the stock market is falling, some speculators may want to profit from the drop. But for some situations, simply shorting a stock or buying a put may seem too risky. In that case, the options strategy called the “bear put spread” may fit the bill. To use this strategy, you buy one put option while simultaneously selling another, which can potentially give you profit, but with reduced risk and less capital. Let’s take a closer look.

 

Understanding the bear put spread
Although more complex than simply buying a put, the bear put spread can help to minimize risk. Why? Because you are hedging your position by buying one put option and selling another put option, which can reduce losses but can also limit your potential profits. And, this strategy involves less capital than simply buying a put.

There is something else you should know about the bear put spread: Because you are paying out money to initiate this strategy, it’s called a debit spread. Your goal is to sell the combined position at a price that exceeds the overall purchase price, and thus make a profit.

 

Put Basics
A put is a contract that gives the owner the right to sell shares of a stock at a set price—known as the strike price. So buyers of puts hope stock prices fall below the strike price, giving them the potential to profit.

One advantage of the bear put spread is that you know your maximum profit (or loss) in advance. In fact, the maximum risk for this trade is the initial cost of the spread. Therefore, you have defined your risk in advance.

 

The nuts and bolts
Normally, you will use the bear put spread if you are moderately bearish on a stock or index. Your goal is for the underlying stock to drop low enough so that both options in the spread are in the money (when expiration arrives), that is, the stock is below the strike price of both puts. You want the stock to fall far enough to earn more than the cost of the spread. Here is one example of how it works:

Buy a put below the market price: You will make money (after commissions) if the market price of the stock falls below your breakeven price for the strategy.

Sell a put at an even lower price: You keep the proceeds of the sale—offsetting some of the cost of the put and taking some risk off the table. You also give up any profits beyond the lower strike price.

The best-case scenario: The stock price falls as you anticipated and both puts are in the money at expiration.

 

Before you initiate the trade—what to look for:
Before you initiate a bear put spread, it’s important to have an idea of your criteria. Here are some general guidelines.

Underlying stock: First, you need to choose an underlying stock that you feel is likely to fall in price.

Expiration date: Choose an options expiration date that matches your expectation for the stock price to fall.

Strike price: Next, you must decide which strike prices to choose.. For example, you may choose to buy the 45 put and sell the 40, or buy the 60 put and sell the 50. The larger the spread, the greater the profit potential, but the difference in premiums might leave you with more risk.

Volatility: Many traders prefer to initiate the bear put spread to help offset volatility or the cost of an option. Volatility is an important factor that will affect options price.

 

Your first bear put trade
Now that you have a basic idea of how this strategy works, let’s look at more specific examples of this strategy.

Note: Before placing a spread, you must fill out an options agreement and be approved for Level 3 options trading.

In June, you believe that XYZ, which is currently at $31 per share, will fall below $30 per share over the next two or three months. You decide to initiate a bear put spread.

You buy 1 XYZ October 30 put (long put) for $3.80 per share, paying out $380 ($3.80 x 100). At the same time, you sell 1 XYZ October 25 put (short put) for $1.60 per share, receiving $160 ($1.60 x 100). Note: In this example, the strike prices of both the short put and long put are out of the money.

Cost: Your total cost, or debit, for this trade is $220 ($380 – $160), plus commissions. To initiate this trade you can place them as one trade by using the multi-leg option ticket.

Maximum possible gain: The most you can gain from this trade is $280. To determine your maximum reward, subtract the net debit ($2.20 x 100) from the difference in strike prices ($5 x 100). In this example, it will be $280 ($500 – $220).

Maximum risk: The most you can lose on this trade is the initial debt paid, or $220.

Let’s take a look at what could go right (or wrong) with this strategy:

Example One: The underlying stock, XYZ, falls below the 30 strike price before the expiration date.

If the underlying stock falls below $30 before expiration, both legs of the spread (each side of the spread, the buy side and sell side, is called a leg) will rise in value.

For example, the long put may rise from $3.80 to $5.70, while the short put may rise from $1.60 to $2.10. Note: Near expiration, as the long put option goes further in the money, the spread between the two put options widens, but it never surpasses that $5 maximum value.

 

How to close a winning trade
Before expiration, you can close both legs of the online trade with the click of one button. In the above example, if you enter a limit order, you buy back (buy to close) the short put for $210, and sell (sell to close) the long put for $570. Your profit is $140: Sale price of $360 ($570 –  $210) minus $220 (your original payment).

Although some traders try to achieve maximum profit through assignment and exercise, it may be risky—it could leave you exposed to a naked stock position. So it may be worth closing both legs of the spread before expiration once your profit goal is reached.

Example Two: The underlying stock, XYZ, remains above the 30 strike price before or near the expiration date.

If the underlying stock remains above $30 before expiration, both legs of the spread drop in value, which is not what you hoped to see. For example, the long put might fall from $3.80 to $2.10, while the short put may drop from $1.60 to $1.20.

To avoid complications, you may want to close both legs of a losing spread before the expiration date, especially if you no longer believe the stock will perform as anticipated. If you wait until expiration, you could lose the entire $220 investment.

 

How to close a losing trade
Before expiration, close both legs of the trade. You will buy back (buy to close) the short put for $120, and sell (sell to close) the long put for $210. In this example, your loss is $130: ($210 –  $120) –  $220 (your initial payment).

 

Early assignment
Although it’s unlikely, there’s always a chance you’ll be assigned early (before expiration) on the short put. If this occurs, you may want to exercise the long put.

 

Other factors to consider
Trading spreads can involve a number of unforeseen events that can dramatically influence your options trades. Make an effort to learn about time decay and implied volatility, and how they can affect your trade decisions.

I will notify you of my posts via twitter@michaelsincere

Understanding OptionsUnderstanding StocksStart Day Trading NowAll About Market Indicators