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Option Strategy Lesson
Author: Price Headley (info)
Website: http://bigtrends.com
Posted: June 19th, 2007 at 8:20 am EST
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One of the things we’d like to start adding to our Daily TrendWatch commentary is an advanced lesson in options strategies.
There are dozens of things you can do with options besides just straight buying and selling. We’ll be reviewing some of our favorite strategies - one at a time - over the course of the next several weeks. We’ll start with some basic ideas, and then use those as the building blocks for more complex ideas. If you aren’t able to use a particular strategy, no harm done. But, you may find one you like.
Here’s today’s….a bull put spread.
Assume for a moment you think a stock is possibly going to move higher, but at worst, you don’t think it will do any worse than just stay flat, or move sideways. How do you make a little money from this, and how do you also protect yourself if you’re wrong? A bull put spread.
This is an income strategy, meaning the goal is to put cash into your trading account at the onset of the trade. Then - hopefully - the spread will expire worthless, and you get to keep the upfront cash you received.
To put that cash in your pocket, you have to sell something - a put option, in this case. Since selling an option is infinitely risky, to protect yourself, you want to buy a little ‘insurance’….in the form of owning a put option on the same stock or index. The net difference between what you receive for the option you sell and what you have to pay for your ‘insurance’ option is where the income is injected into your account - it’s called a credit. Let’s look at an example….
Say you’re neutral to bullish on Altria (MO). Currently trading at 70.46, you’d create a bull put spread by selling (shorting) a put with the next strike below the current price, and then buying the same number of puts with the next strike under that one (they should expire in the same month). In Altria’s case, you’re talking about selling next month’s 65 put at 15 cents, and buying next month’s 60 put at 5 cents. The net difference between the two is your credit of 10 cents….which may not seem like much, but multiply that times 100 shares per contract, and then multiply that number by - let’s just say twenty contracts - and your net credit is $200, minus commissions ($300 - $100).
As long as Altria stays above 65 until the options expire, the options will be worth nothing upon the next expiration, and you get to keep the $200.
Your risk in all this? If MO falls under 60, then both the puts are now back in the money. The puts with a 65 strike would be exercised against you, but you’d exercise the 60 puts in your favor. The net cost to you to do all of that that would be $500 per contract, which can be quite a bit, relatively speaking. However, considering you’re five points out of the money to begin with, you really should make an exit well before you get in that situation……before the 65 strike actually gets back into the money.
In other words, you really don’t want MO shares to fall under 65 before you close out the trade. (And to close out the trade, just sell the 60 strike, and buy back the 65 strike.) After all, it’s a neutral to bullish trade, and if the stock turns bearish, the trade strategy just isn’t going to work.
The advantage to a bull put spread as opposed to a traditional bullish call spread is time decay. You’re accomplishing the same basic thing with both, but with a bull put spread, you’re taking advantage of time decay. With a regular bullish spread, time decay is working against you.
We encourage you to paper trade a couple of these ideas, as learning is much easier by doing. You’ll probably find that there are much better risk/reward scenarios than the Altria one, which is actually a trade we’d probably NOT take (though it was fine as an example).
We’ll add another dimension to this strategy later in the week.
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Price Headley
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