Monday, September 21, 2009

Mail Bag

Let's take one more crack at the Best Buy earnings play before we put this baby to rest. I received the following questions in response to the 1 x 2 put spread trade idea.

What are the primary differences between a 1x2 put spread and a regular put spread?

On the BBY play, why would you not buy the ATM (40) and sell the 1st OTM 37.50 ?

First off let's contrast the 1x2 put spread vs. a straight put spread, taking a look at the numbers then hashing out the notable differences between the two.

37.50- 35 put spread
Long (1) Sep 37.50 put @ $.50
Short (1) Sep 35 put @ $.15
Net Debit = $.35
Max Reward = 2.15

37.50-35 1 x 2 put spread
Long (1) Sep 37.50 put @ $.50
Short (2) Sep 35 put @ $.30
Net Debit = $.20
Max Reward = $2.30

Notable differences:
1. The 1x2 put spread is cheaper because we're shorting an extra put option.
2. The 1x2 put spread is more sensitive to changes in volatility (negative vega). This should be intuitive since we sold twice as many options as we bought. If volatility decreased as the stock dropped in value, that would decrease the value of the short options more than the value of the long option. When options seem overpriced it's tempting to enter the 1x2 spread and sell more premium.
3. The 1x2 put spread can lose money if the stock drops too far; the regular put spread can't. This is due to the fact that the 1x2 put spread involves selling a naked put. Keep this in mind when choosing which stocks your going to play and which strikes you choose. The reason I was comfortable selling the extra naked put on BBY was because I thought the odds of BBY probing below $32.65 (my breakeven point) were negligible.

Now, why use the 37.50 and 35 strikes instead of the 40? At the time of the trade suggestion, BBY was trading around $40.

The primary reason one would use further OTM strikes (like 37.50 and 35) would be to lower the cost of the trade. The 40-37.50 1x2 spread was trading around $.80. The 37.50-35 spread was trading around $.20. It also shifts your profit zone. The former trades max profit comes around $37.50 the latter comes at $35.
In hindsight, the 40-37.50 spread would have worked a lot better. After earnings BBY settled right around $37.50 resulting in a tidy profit for that trade.

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