Sunday, March 29, 2009

Your Weekly Dose of Options Action!

I was able to tune into Options Action on Friday night. Over the past few weeks they’ve done small segments on options education in each episode. They typically give an overview of specific option trades and this Friday was no exception as they reviewed bull put spreads.

I was quite pleased with the succinct overview and wanted to elaborate on a few of the points they mentioned. On the show they referred to the strategy as “selling a put spread”. Selling a put spread is also often referred to as a bull put spread. “Buying a put spread”, on the other hand, is also considered a bear put spread. Option spread trades are commonly classified into three different categories:

Vertical Spreads: Buy and sell different strikes in the same expiration month
Horizontal Spreads: Buy and sell same strikes in different expiration month
Diagonal Spreads: Buy and sell different strikes in different expiration month

Because the bull put spread consists of simultaneously buying and selling different strike put options in the same expiration month, it is a vertical spread.

Sell a higher strike put and simultaneously buy a lower strike put of the same expiration month.

Time Frame:
The suggestion made was to go far out enough in time to bring in an adequate credit – and I whole heartedly agree. I generally enter put spreads around 4 to 6 weeks to expiration. Although shorter term put spreads experience more time decay (due to a higher theta), there is less extrinsic value remaining in the options, resulting in less credit received. You’ve got to be the judge as to whether there is enough premium, and that brings us to the next subject…

When assessing any potential put spread, it is essential to ensure the risk-reward fits your comfort level. The recommendation was to seek a risk-reward of 3 or 4 to 1. For example, if I enter a $5 wide spread, I would want at least $1 credit (risk $4 to make $1). If I entered a $10 wide spread I would want around $2.00 credit (risk $8 to make $2). I’m not as much of a stickler on the ratio being 4 to 1. I commonly enter $10 spreads for a mere $1 credit. Generally shooting for $1 credit allows me to sell further out-of-the-money puts, than if I tried for $2 credit. These further out-of-the-money options have a lower delta, which translates into a higher probability of profit for me.

Risk-Reward Formulas:
Max Reward = Net Credit
Max Risk = Difference between long and short put strike prices
Breakeven = Higher strike put – net credit
Probability of Profit = 1 – delta of short put

Bull Put Spread example:
One of the members of the round table discussion suggested an Aug 30-25 bull put spread on Caterpillar (CAT). Let’s check out the risk-reward characteristics and risk graph:

CAT is currently trading at $30.35 and the expectation was for CAT to exhibit neutral to bullish price action over the next 5 months.
Sell to Open Aug 30 put for $4.50
Buy to Open Aug 25 put for $2.50
Net Credit = $2.00
Max Reward = $2.00
Max Risk = $3.00
Breakeven = $28
Probability of Profit = 1 - .39 (delta of 30 put) = .61 or 61%

I tend to think 5 months is a bit too far out for bull put spreads, particularly when the stock is already through the spread (above $30). Because the stock is already above $30, to net our maximum reward, we're really just waiting for extrinsic value to decay out of the option premiums. An Aug put spread isn't going to realize near as much time decay as a shorter term spread. That being said, you may consider the May 30-25 put spread. That cuts the time to expiration from 5 months to 2 months. The net credit is about $1.72, a mere $.28 less than the Aug spread.


1 comment:

Tee Chess said...

Thank you for sharing your experience. The strategy that you have followed is really nice. I will make use of your experience and considers all the points that you have posted.
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