THE OPTIONS COURSE
BULL PUT SPREAD
A bull put spread is a credit spread created by the purchase of a lower strike put and the sale of a higher strike put using the same number of options and identical expirations. The maximum reward of this strategy is limited to the credit received from the net premiums and occurs when the market closes above the strike price of the short put option.
Therefore, this strategy is implemented when you are bullish and expect the market to close above the strike price of the put option sold. The maximum profit of a bull put spread is limited to the net credit received on the trade. The maximum risk is calculated by subtracting the net credit from the difference in strikes and then multiplying this number by 100. The breakeven of a bull put spread is calculated by subtracting the net credit from the higher strike put.
Choosing the Options
In order to choose the options with the best probability of profitability for a credit spread—bull put and bear call spreads—it is important to balance out five factors:
1. The profit on these strategies depends on the options expiring worthless; therefore, it is best to use options with 45 days or less until expiration to give the underlying stock less time to move into a position where the short put will be assigned and the maximum loss occur.
2. Since the maximum profit is limited to the net credit initially received, keep the net credit high enough to make the trade worthwhile.
3. Keep the short strike at-the-money—try to avoid selling an in-the-money put.
4. The difference between strikes must be small enough so that the maximum risk is low enough to make the trade worthwhile.
5. Make sure the breakeven is within the underlying shares’ trading range.
Bull Put Spread Mechanics
Let’s say you are bullish on XYZ, currently trading at 44. You expect a move upward for a close above 50 by next month. To initiate a bull put spread, you sell a higher strike XYZ June 50 put at $7.50 and purchase a lower strike XYZ June 45 put at $3. Both strikes are close enough to allow XYZ to reach the projected strike price of 50. Remember, the object of this strategy is to have both options expire worthless and be able to keep the net credit. In this example, the maximum reward is the net credit of 4.50, or $450 per contract. The breakeven occurs when the underlying asset’s price equals the higher strike price minus the net credit.
In this case, the breakeven equals 45.50: (50 – 4.50 = 45.50). This trade makes the maximum profit if XYZ closes at or above 50 at expiration. You get to keep a lesser portion if the trade closes between 45.50 and 50. As long as XYZ closes above the breakeven point of 45.50, you won’t lose money. The maximum risk is calculated by subtracting the net credit from the difference between strike prices multiplied by 100. In this trade the maximum risk is $50: (50 – 45) – 4.50 × 100 = $50. Therefore, if XYZ closes below 45, you lose $50.
FIGURE Bull Put Spread Risk Graph
The risk profile of a bull put spread slants upward from left to right displaying its bullish bias. If the underlying shares rise to the price of the short put, the trade reaches its maximum profit potential. Conversely, if the price of the underlying stock falls to the strike price of the long put, the maximum limited loss occurs. Always monitor the underlying stock for a reversal or a breakout to avoid the maximum loss.
Exiting the Trade
To exit a bull put spread, you have to monitor the daily price movement of the underlying stock and the fluctuating options premiums. Although each trade is unique, let’s explore what happens to the trade in the example in the following scenarios:
• XYZ rises above the short strike (50): Let the options expire worthless and keep the maximum credit received when the trade was initiated ($450).
• XYZ stays above the breakeven (45.50), but does not rise above the short strike (50): The short put is assigned and you are obligated to purchase 100 shares of XYZ from the option holder at $50 a share. You can sell the shares at the current price, which is above the strike price of the long put and incur a small loss that can be offset by the initial credit received. You can also offset the long put by selling it to garner an additional profit.
• XYZ falls below the breakeven (45.50), but stays above the long strike (45): Once again, the short put is assigned and you are obligated to purchase 100 shares of XYZ from the option holder at $50 a share. You can sell the shares at the current price, which is slightly above the strike price of the long put. In this case, the loss on the shares will not be balanced out by the credit received. Selling the long put may bring in additional money to mitigate some of the loss.
• XYZ falls below the long strike (45): The short put is assigned and you are obligated to purchase 100 shares of XYZ from the option holder at $50 a share. You can now exercise the long put to sell the shares at $45 each, incurring the maximum loss of $500, which is balanced by the $450 credit received at initiation for a total loss of $50 (plus commissions).
Bull Put Spread Case Study
A bull put spread is a credit strategy that benefits when the underlying security trades sideways or higher. Stocks often hit support, which sends the stock higher. At these times, using an at-the-money credit spread can bring in profits. A credit spread profits if the stock moves in two of the possible three directions a stock can move. Both a bear call spread and a bull put spread benefit from sideways movement, with the former benefiting from a down move and the latter from an up move.
A bull put spread consists of selling a put and buying a lower strike put. The sale of the higher strike put brings in premium, which is larger than the cost of purchasing the lower strike put. What we then have is a limited risk/limited reward strategy. Unlike a debit spread, though, the risk is often higher than the reward while the odds of success are usually very high. On December 11, 2003, shares of Inco Limited (N) formed a bullish formation.
The stock closed the session at $34.86, but it looked as if the stock would move higher and use $35 as support. Using this forecast, a bull put credit spread could have been implemented. Since a credit spread benefits from time decay, it’s usually best to use front month options. However, the December option had just six days left, so we would have used the January options. By selling the January 35 put for 1.65 and buying the January 30 put for 0.35, this bear call spread would have brought in a credit of $1.30 per contract.
FIGURE Risk Graph of Bull Put Spread on N
This bullish credit spread would see the maximum profit achieved as long as shares of N were at or above $35 on February 20, which was options expiration. The maximum risk is calculated by subtracting the net credit per contract of $1.30 from the difference between strikes (30 – 25 = 5). Therefore, the maximum risk is $370 per contract [(5 – 1.30) × 100 = $370] or $1,850 for five contracts. The breakeven is calculated by subtracting the net credit of 1.30 from the higher strike of 35.
Thus, the breakeven for this trade was at $33.70. Once again, let’s assume the trade consists of five contracts for a maximum profit of $650. Shares of N did indeed move higher from this point, leaving the trader with the maximum profit of $650. In this example, the trader had to do nothing but watch the options close worthless, leaving the entire credit in the trader’s account.
BEAR CALL SPREAD
A bear call spread consists of selling a lower strike call and buying a higher strike call using the same number of options and identical expiration dates. This is a credit trade when initiated and makes money when the market closes below the strike of the short option. This strategy is used when you have a bearish view of a market. It offers a limited profit potential with limited risk. The maximum reward is achieved when the closing price of the underlying security is below the lower strike call, yielding the full net credit for the trade.
Therefore, this trade should be implemented by selling options that have a high probability of expiring worthless so you can keep the net credit. The maximum risk is equal to the difference between strike prices minus the net credit times 100. The maximum risk occurs when the stock or futures contract closes at or above the strike price of the option purchased. This means that the short option will have increased in value while the one purchased has not increased in value as much. The breakeven is calculated by adding the strike price of the lower call to the net credit received.
Bear Call Spread Example
Let’s say XYZ is trading at $51 and you think it’s ready for a correction. You decide to initiate a bear call spread by going short 1 XYZ June 50 Call @ 3.50 and long 1 XYZ June 55 Call @ 1.00. When you initiate this trade, you receive a credit of 2.50, or $250 per contract: (3.50 – 1.00) × 100 = $250. This is the maximum reward that would be earned at expiration if XYZ closes at or below $50 per share. Since the maximum risk is equal to the difference between strike prices minus the net credit, the most you can lose in this example is $250: (55 – 50) – 2.50 × 100 = $250.
Maximum risk occurs if XYZ closes at or above 55. The short option would have a value of 5: (55 – 50 = 5). The long 55 call would expire worthless; therefore, your position would lose 5 points, or $500 if the position closes at the higher strike price. However, you received a credit of $250; therefore, your risk is a net $250: ($500 – $250 = $250). The breakeven on this trade occurs when the underlying stock price equals the lower strike price plus the net credit. In this trade, the breakeven is 52.50: (50 + 2.50 = 52.50).
The trade breaks even or makes money as long as XYZ does not go above 52.50 at expiration. The risk graph of a bear call spread slants downward from left to right, displaying its bearish bias. If the underlying shares fall to the strike price of the short call, the trade reaches its maximum profit potential. Conversely, if the price of the underlying shares rises to the strike price of the long call, the maximum limited loss occurs. Always monitor the underlying shares for a reversal or a breakout to avoid incurring a loss.
Exiting the Trade
• XYZ rises above the long strike (55): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $50 per share. By exercising the long call, you can turn around and buy those shares at $55 each, thereby losing $500. This loss is mitigated by the initial $250 credit received for a total loss of $250 (not including commissions).
FIGURE Bear Call Spread Risk Graph
• XYZ falls below the long strike (55), but not below the breakeven (52.50): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $50 a share by purchasing XYZ at the current price. This loss is mitigated by the initial $250 credit received. You can also sell the 55 call to offset and further reduce the loss.
• XYZ falls below the breakeven (52.50), but not as low as the short strike (50): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $50 a share by purchasing XYZ at the current price. The loss is offset by the initial $250 credit received. Selling the 55 call can bring in some additional money to offset the loss.
• XYZ falls below the short strike (50): Let the options expire worthless to make the maximum profit of $250.
Bear Call Spread Case Study
A bear call spread is a credit strategy that benefits from the underlying security trading sideways or lower. Stocks often run into resistance, which impedes higher movement. At these times, using an at-the-money credit spread can bring in profits. A credit spread profits if the stock moves in two of the possible three directions a stock can move. A bear call spread benefits from sideways movement as well as a decline in prices.
Let’s review: A bear call spread consists of selling a call and buying a lower strike call. The sale of the higher strike call brings in premium that is larger than the amount it costs to buy the lower strike call, thereby creating a limited risk/limited reward strategy. However, unlike a debit spread, the potential loss on a credit spread is almost always higher than the potential profit. However, the odds of success are very high, which is why these strategies are worthy of additional study.
On September 23, 2003, shares of Monster Worldwide (MNST) were showing bearish tendencies. The stock closed the session on September 24 at $27.74 and it looked likely that $25 would be broken. During the next session, it was possible to enter a bear call spread for a nice credit. Since a credit spread benefits from time decay, it’s important to use front month options. By selling the October 25 call for 3.10 and buying the October 30 call for 0.70, this bear call spread would have brought in a credit of $2.40 per contract. The maximum risk would be $2.60 per contract, which is a rather good reward-to-risk ratio for a credit spread.
In two out of every three cases, credit spreads expire with the trader keeping the entire credit. This is because traders of bear call spreads profit if the stock stays constant or moves down. For this example, the maximum reward is the credit received, which for five contracts would be $1,200. The maximum risk is found by subtracting the credit per contract from the difference between strikes (30 – 25 = 5). Thus, the maximum risk is $260 per contract [(5 – 2.40) × 100 = $260)] or $1,300 for five contracts, and the reward/risk ratio is 0.92 to 1.00. The breakeven is determined by adding the initial credit to the lower strike, or 27.40: (25 + 2.40 = 27.40).
FIGURE Risk Graph of Bear Call Spread on MNST
So let’s take a look at what happened in the real world. Shares of MNST traded near $25 for the next week, but on October 10, they shot sharply higher. However, the upper strike was not penetrated, with the high of the session coming at $29.35. During the next week, shares of MNST fell and on expiration Friday, October 17, the stock traded as low as $25 and the short call could have been purchased back for anywhere from $0.25 to $1.70. In this case, the October 25 call was purchased back for $0.45, leaving a profit of $195 per contract or $975 for all five contracts.
Now that you’ve been introduced to spread trading, there are a few mechanical realities that must be dealt with—namely, getting your spread order filled at a price you can live with. There are many factors involved between the time you hit the send button and the time you receive confirmation that your spread has been “filled.” Before you hit send, make sure you assess the bid/ask price of the spread. The bid is the highest price a prospective buyer (trader or dealer) is prepared to pay for a specified time for a trading unit of a specified security. Thus, the bid is also the price at which an investor can sell to a broker-dealer.
The ask is the lowest price acceptable to a prospective seller (trader or dealer) of the same security. The ask, therefore, is the price at which an investor can buy from a broker-dealer. Together, the bid and ask prices constitute a quotation or quote and the difference between the two prices is the bid-ask spread. Sometimes you may have a hard time cutting the bid/ask on a spread, and even miss getting filled at or above the asking price. What I’m talking about is a common occurrence that goes something like this:
You like stock XYZ, which is trading at 110. You decide you’d like to go four months out on the 100/120 bull call spread. The bid on the spread is 5.50 and the ask is 6.50. In other words, if you owned the spread, it would have a selling value of 5.50. If you were buying the spread it would have an asking price of 6.50. Not wanting to pay what the market is asking, you put in a limit order of 6 on the buy side, meaning that you’ll pay up to $600 for the spread. As the day wears on, you check your account online and see you haven’t been filled. The stock dips some, and you check the bid/ask on the spread again; it’s now 5.75 bid, 6.75 ask.
Still you haven’t been filled, and you’re feeling frustrated! What’s going on? Here’s the explanation: In order to complete a spread as a single transaction, the traders on the floor must find market makers to match up both sides of the spread in a single transaction. There has to be someone willing to sell a 100 call while someone else buys a 120 call. This is a much more difficult task than simply selling or buying calls as individual transactions. So, even though you may only be trying to cut the bid/ask by a small amount, it can be difficult to get a market maker to take this as a combination order.
This is especially true in fast moving markets where scores are being reeled off in hundreds of individual contracts. Now the trader who has your ticket has the market maker stop, calculate the net amounts, and then make a decision. I had an interesting and frustrating event a few months back that will shed some light on this topic. I wanted the August YHOO 55/65 bull call spread at 5.50. The bid/ask was approximately 5 and 6, so I was trying to shave a small amount, half a point. Hours went by and I checked again.
YHOO had dipped intraday as I expected, and I was looking for my fill confirmation. The ask was now 5.75 and I still didn’t have my order filled! I had the head of my brokerage office call down to the floor and I learned that in a fast moving market (as it was) no one wants to stop to calculate a spread when individual calls and puts are flying back and forth in lots of 20, 50, or 100 contracts on a stock like YHOO. I could have legged in, but I have a rule that I trade a vertical spread only as a limit order on the cost of the overall spread—no legging in. So I missed the trade.
However, sometimes this situation can work to your advantage. Let’s say you offer 8.50 on a spread that was bid/ask at 7.50 and 9.50. Then the underlying stock, XYZ, starts to fall; the ask on the spread had fallen to 7.75. You decide to cancel and try the trade again when it’s on the way up. You hold your breath, hoping you didn’t already get filled as the asking price passed down through your offer of 8.50. Sure enough, you get your cancel confirmation in a little while and breathe a sigh of relief.
Sure, XYZ will likely come back, but it would be better to place the bull call spread buy on the way up than on the way down—unless you’re specifically targeting a certain price. One more piece of advice: Don’t chase the market. I sometimes wish I had raised my offer on YHOO; but I won on that transaction anyway because I stuck to my principles. Besides, the money I would have put in YHOO is working for me in another trade. If you wish to leg in (buying the lower call, then selling the higher call), be sure you’ve solidly confirmed the market direction first.