Thursday, April 2, 2009

Trading Lab Recap - Choosing Strikes for Bear Put Spreads

With the bear put spread and all debit spreads, we can increase/decrease the risk-reward ratio, and probability of profit by changing the strike prices we use. Let’s look at 3 bear put spreads on CNX.

CNX is currently trading at $26.32

Bear Put #1
Buy May 30 put for $5.70 1st strike ITM
Sell May 25 put for $2.70 1st strike OTM
Net Debit = $3.00
Max Risk = $3.00
Max Reward = $2 (5 – 3)
Breakeven = $27 (30 – 3)
To realize max profit, we need the stock below $25

Bear Put #2
Buy 25 put for $2.70 1st strike OTM
Sell 20 put for $1.00 2nd strikes OTM
Net Debit/ Max Risk = $1.70
Max Reward = (5 – 1.70) = $3.30
Breakeven = 25 – 1.70 = $23.30
Cheaper – less risk- more potential reward
To realize max profit, we need the stock below $20

Bear Put #3
Buy 35 put for $10.00 2nd strike ITM
Sell 30 put for $6.00 1st strike ITM
Net Debit = $4.00
Max Risk =$4.00
Max Reward = $1 (5 – 4)
Breakeven = $31
To realize max profit we need the stock below $30

How do I choose which strike prices to use?
Starting out, most debit spread traders probably use the following strikes:
Buy 1st strike ITM, sell 1st Strike OTM

Out-of-the-money bear put spread: Buy 1 strike OTM, sell 2 strikes OTM
OTM bear put spreads are cheaper, have less capital at risk, have more potential reward, but require the stock to drop in price more b/c they have a lower breakeven

In-the-money bear put spread: Buy 2 strikes ITM, sell 1 Strike ITM
ITM bear put spreads are more expensive, have less potential reward, but doesn’t require the stock to drop as much in price b/c they have a higher breakeven

My personal preference is to use OTM debit spreads. I’m willing to accept a lower breakeven (stock has to move more), in return for a lower risk – higher reward trade.

My odds of being assigned are high when:
Short option is ITM
Short options has little to no extrinsic value left
If it comes to the point where the short put (bear put spread) has little to no extrinsic value left, that means you’ve made almost all your profit

Trade Reviews:
AZO $166
Outlook: Bullish
Strategy: Bull Put Spread
Sold APR 145 @$1.89
Buy APR 135 @$.91
Net Credit = $1
Max Reward = $1
Theoretical Max Risk = $9

2 types of risk:
Theoretical Risk (if trade goes completely wrong & I hold all the way to expiration)
Managed Risk (how much I could lose based on my stop loss)

1: Hold to expiration to realize enter $1 profit
2: Exit early when achieved 80% of max profit

Trade Management
1: Exit if stock breaks support
2: Exit when lose 30% of max risk
Why would I be willing to risk $9 to make $1? B/c the probability of profit was around 90%.


Anonymous said...


Excellent resource and good examples. I not only learn from your posts but also hope I can make some dough...question for you: You like to play collecting the premiums strategy, but how do you know what stock to get into to execute this strategy? Do you also do fundamental research or let the charts do the work for you? Also do you go for stocks above a minimum price such as say $20 . Also do you go for 6months options if you want to collect the premiums and at the same time, if stock moves against you, you don't mind buying it at the strike price? (e.g. you sold a naked put)



Excellent evaluation.