Wednesday, March 25, 2009

Trading Lab Recap- Part 1 Bear Puts

In tonight's trading lab, Bear put spreads and exercise and assignment were the topics of discussion. Part I of the notes will cover Bear Puts, Part II will cover exercise & assignment.

Signs of a Top:
These price patterns can develop on any time frame:
Slowing Momentum (distance between pivot highs starting to compress)
Double Top (equal pivot highs)
Head & Shoulders (lower pivot high in the midst of an uptrend)

Bear Put Spread
Vertical Debit Spread
Market Outlook: Bearish
Structure: Buy a higher strike put and simultaneously sell a lower strike put in the same month
I generally use 2 month or longer options to allow the stock adequate time to reach the short strike price-

Drastically reduce the cost and risk of the trade
Higher Breakeven (stock doesn’t have to move as far)
Higher probability of profit than outright put purchase

Limited yet substantial reward
Debit spreads are considered more position trades

Risk-Reward Characteristics:
Net Debit = price of put bought – price of put sold
Max Risk = Net Debit
Max Reward = Spread between strike prices – net debit
Breakeven = Higher strike put – net debit
ROI = Reward / Risk

Technique One:
Hold to expiration to net the max reward
Technique Two:
Exit when I’ve achieved 40-60% of the max reward

Trade Management:
Technique One:
Exit if stock breaks above resistance
Technique Two:
Exit when I lose 50% of max risk

Put vs. Bear Put Spread
ISRG @ $96
Buy May 95 put for $9.00
Max Risk = $9
Max Reward = unlimited

Buy May 95 put for $9.00
Sell May 90 put for $6.70
Net Debit = $2.30
Max Risk = $2.30
Max Reward = $5 – 2.30 = $2.70
ROI (return on investment) = $2.70 / $2.30 = 117% return

Long 95 put, I have the right sell the stock @ $95
Short 90 put, I’m obligated to buy the stock @ $90

Expiration – stock is at $80
95 put is worth $15 (Profit $15)
90 put is worth $10 (Loss $10)
Net Profit = $5 - $2.30 = $2.70

I can eliminate the chance of whipsaw by proper position sizing: If enter (1) bear put spread on ISRG with a max risk $230, I don’t have to use a stop loss, as long as my risk management rules allow me to risk more than $230 a trade.
I'll post the notes on Exercise & Assignment tomorrow.


Anonymous said...

Great stuf, Tyler.... Visit your blog at least once a day - please keep it up.

What software do you use to generate graphic representation of options used in this post?

Tyler Craig said...

All the risk graphs and charts that I post are from the EduTrader software. Here's the website for it if you want to check it out:



Excellent views on puts.