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-

Advantages:
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

Disadvantages:
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

Target:
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.

3 comments:

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: http://www.edutradersoftware.com/

Tyler-

QUALITY STOCKS UNDER 5 DOLLARS said...

Excellent views on puts.