Options Trading

Bull Put Spread

Armed with an understanding of the vocabulary and techniques of basic options strategies, you can now move on to more advanced applications. Thus, the first true spread strategy to consider is the Bull Put Spread.

As with most options strategies discussed here, the key to understanding how a Bull Put Spread works is to analyze the name. The term "bull" refers to your sentiment on the likely trend of the stock. Thus, you're hoping the stock goes up, but not too much.

Note:

spread strategies are best used in sideways/neutral markets. If you're fairly certain a stock will increase in price, you're probably better off buying the Call option on that stock than using a spread and potentially putting a cap on potential gains.
Here's how a Bull Put Spread works:

How the Bull Put Spread Works

Let's suppose you find an optionable stock that's trading in a sideways pattern. You've checked the news and you know when the next earnings announcement is expected. You've determined there shouldn't be any surprise announcements that could unexpectedly move the price of the stock over the next few weeks.

Now, let's say the stock you're considering is currently trading for $26 per share. You don't own the stock, but you're considering an options play on it, for the sole reason that your neutral expectation for the stock price doesn't justify purchasing the stock itself.

If you think the stock will continue to trade flat or in a very slight up-trend, you can generate a bit of income while minimizing your risk using Put options. This means you're not expecting the stock to drop, so the Put contracts you trade should expire worthless. The reason the Bull Put Spread strategy is considered a "credit" spread is that once all the transactions are complete for entrance into the position, you have a net credit to your account.

The Process

If you are already approved for Level 4 trading authority, which allows you to sell naked Puts, your first step is to sell the $25 strike Put. Let's say the bid price for the $25 Put is $2 per share ($200 per contract). Upon completion of the transaction, you now assume the obligation to purchase the stock for $25 per share if the stock price closes below $25 by expiration. You receive $200 to motivate you to accept the obligation.
Now, take the $200 revenue you received from selling the $25 Put and use it to buy the Put option one strike price lower at $22.50 (note: if you are only approved for Level 3 trades, your broker won't allow you to sell a Put first). To buy a Put, you need to pay the ask price, which acts as a covering asset for the deeper in-the-money Put you sell. Thus, to buy the $22.50 Put option, you'll pay the ask price of $1 ($100 per contract). You spend $100 of the initial $200 you received to buy the $22.50 Put, leaving a surplus of $100. Hold on to that surplus, you may need it later.

To this point, you've assumed the obligation to buy the stock for $25 per share and you have purchased the right to sell the stock for $22.50.

Potential Profit:

Your maximum profit from this transaction is the $100 surplus you retain after buying the $22.50 Puts. As long as the stock goes along with your neutral to slightly up-trending forecast, you're able to keep that surplus.

Potential Risk:

If the stock falls below the $25 strike price, you'll be assigned the stock or obligated to buy it for $25 per share. To avoid this, you can buy the Put back, thereby removing your obligation - but this may not be in your best interest. As the stock falls, the value of the $25 Put increases. It's likely you'll have to pay more to buy it back than you received in revenue from the transactions you've made up to this point. However, remember that you still hold the Put contract you purchased at the $22.50 strike price. This gives you the right to sell your stock for $22.50 per share. The worst-case scenario consists of buying the stock at $25 per share and exercising the $22.50 Put to sell the stock at $22.50 per share, for a total loss of $250.

To get this figure, note that you have been required to buy the stock at $25 per share, while you can sell the stock at $22.50 per share ([$22.50 x 100 shares = $2,250] - [$25 x 100 shares = $2,500] = -$250); this represents a loss of $250. Now, you could take the $100 surplus you received from the sale of the $25 Puts and use it to ease the $250 loss, reducing your "worst-case scenario" maximum loss to $1.50 per share, or $150 total.

The return on risked capital for this transaction is calculated by taking the return revenue ($100) divided by the maximum potential loss ($150): $100 / $150 = 66% return.

Let's examine another example using real figures drawn from the Website tools. For this example, let's assume you have Level 3 trading authority, which requires that you purchase one or more Put contracts before you sell the Puts for another strike price.

Case Study:

Through a search, you find the stock for the biotechnology company XYZ (symbol: XYZ) trading in a slight upward trend at a price of $33.51 per share. You decide to enter into a Bull Put Spread by first buying the $25 strike price Put. You pay the ask price of $0.15 per share, or $15 per contract. Then you sell the $30 Put for a bid price of $1.15 per share, or $115 per contract. Subtract the cost of the $25 Put you sold from the $30 Put you bought for $100 in revenue ($115 - $15 = $100).

The maximum risk for this play is the $500 difference in price of the $30 per-share Put paid to purchase the stock if it closes below $30 per share by expiration ($3,000), and the $25 per-share price received when you exercise the $25 Put you purchased ($2,500). To ease the $500 loss, subtract the $100 in revenue you received from the sale of the $30 Put, minus the price to buy the $25 Put. Your maximum loss is $400 ($500 - $100 = $400). The return on risked capital is calculated by taking the amount of revenue you received ($100), divided by the maximum loss ($400): $100 / $400 = 25% potential return.

Your maximum potential gain is the $100 left after buying the $25 strike price Put.

At this point, the stock will move in one of three directions: up, down, or sideways. Here is how to handle each of these scenarios:

XYZ Corporation (XYZ) Moves Upward:

If the stock price goes up, the Put option expires worthless and you keep your $100 profit. Your potential return on risked capital is 25%.

XYZ Corporation (XYZ) Moves Sideways:

In this case, again the Put expires worthless since the stock price never falls below the $30 strike price you sold. You keep the $100 in profit for a return on risked capital of 25%.

XYZ Corporation (XYZ) Slightly Falls, to $29.50:

If the stock drops slightly below the strike price of the Put you sold but stays above the strike price you bought, you could buy-to-close the Put option you sold. The Put you bought will expire worthless.

For example, if XYZ falls to $29.50 on expiration Friday, buy-to-close the $30 Put you originally sold in order to avoid being assigned the stock. Since the stock is now trading for $29.50 and the options are due to expire that same day, there is no time value remaining. The only component still influencing the price of the option is the intrinsic value of $0.50 per share ($30 - $29.50 = .50). Thus, you'll need to pay $50 per contract to buy back the Put. Since you originally held $100 in profit from the first set of transactions, your net profit from the trade drops to $50 ($100 - $50 = $50).

XYZ Corporation (XYZ) Drops to $28.50:

If XYZ falls to $28.50 on expiration Friday, as with the previous case, buy back the $30 Put to avoid being assigned the stock. With the stock now $1.50 below the strike price, you will have to pay $150 per contract to buy the option back. Subtracting this cost from the initial revenue you received from the sale of the options of $100, you would experience a net loss of $50 per contract on the trade ($150 - $100 = $50).

Comparing these examples, it becomes clear that if the stock falls below your strike price and the sooner you're able to buy back the Put, the better.

XYZ Corporation (XYZ) Falls to $24:

Let's say XYZ falls to $24 by expiration Friday. To avoid catastrophic losses, consider buying back the $30 Put to avoid being assigned the stock. With a stock price of $24 per share, there is $6 per share of intrinsic value to the Put ($30 - $24 = $6), requiring a payment of $600 per contract to remove your obligation to purchase the stock for $30 per share. Though this is probably upsetting, remember, you still own the $25 strike price Put. So as the stock has fallen, this has increased in value. With the stock price sitting at $24 per share, your $25 Puts have gained $1 per share in intrinsic value. If you sell them now, you will receive $100 per contract. This revenue, coupled with the original $100 in revenue you received from the initial transactions, means you could ease the $600 loss from the buy-to-close transaction to back out of the $30 Put. Your maximum loss for the transaction is now reduced to $400 ($100 + $100 - $600 = $400).

XYZ Falls to $28:

In this scenario, you may want to consider backing out of the $30 Put you sold and letting the $25 Put appreciate on the forecast of continued weakness, especially if the stock looks to continue appearing weak for the next few weeks or days leading to expiration Friday. The key here is the amount of time remaining until expiration.

If the stock falls to $28, you will have to spend a little more than $2 per share to buy the Put back, as there is still some time value prior to expiration. Remember, whatever price you pay to buy back the $30 Put counts against your profit. To execute this strategy, place a buy-to-close order to back out of the $30 Put and leave the $25 Put to appreciate in value as the stock price continues to fall. Even though you've taken a bit of a loss in backing out of the $30 Put, you may end up profitable overall. The $25 Put will continue to increase in value, depending on how far and fast the stock price falls before expiration. Regardless of how profitable the $25 Put becomes, you must sell it before the trading day ends on expiration Friday or the entire position is lost.

Assigned Early:

If the stock price falls below the $30 strike price you've sold, you run the risk of being assigned the stock. This can happen at any time prior to expiration Friday, although this isn't likely to happen.

The reason you're not likely to be assigned prior to expiration is due to the person on the other end of your transaction. As the Put seller, you assume the obligation to purchase the stock for $30 per share at any time the Put buyer decides to exercise his or her option. The Put option buyer has all the advantages. In other words, the person who bought your Put contract is bearish on the stock. He or she expects the stock to drop in value below the $30 strike price; his or her profit is determined by how far the stock falls - the further it falls, the greater the profit. If the option is exercised early, he/she throws away any potential for the stock to generate further profit.

If you find you've been assigned the stock, you'll receive notice from your broker after the market closes. You'll have until the next trading day to buy or sell the stock, paying the difference between the assignment price and the price at which you are able to sell the stock.

Summary:

With a Bull Put Spread, you are expecting the stock to increase in value or remain neutral. A Put is the type of option often used for this strategy and it is called a spread because you plan to use two different Put option strike prices to generate revenue and help protect yourself against a severe drop in the price of the stock.

If you have Level 4 trading authority, you can first sell a Put option contract one strike price lower than the current price of the stock, which gives you cash up-front, and then purchase a Put contract of the next lower strike price using the revenue collected from the sale of the Put. If you are only authorized for Level 3 trades, consider purchasing the Put contract first, covering your position, and then sell the Put contract one strike price below the at-the-money strike. Whether or not you first buy the Put or sell the Put, it will likely result in a net profit for the position from the start. Hold on to this profit, you might need it later.

If the stock price stays neutral, the Put you sold expires worthless, but that's not a bad thing since you were paid up-front. The Put you bought also expires worthless. Thus, the net effect is your maximum profit.

In the event the stock price falls below the strike price you sold, you may want to act quickly to back out of the trade by placing a buy-to-close order. This removes your obligation on the Put you sold to avoid being assigned the stock.

If the stock falls below the strike prices of both the contract you sold and the contract you bought, first identify how much time remains until expiration. If you have several days before expiration Friday, consider a buy-to-close order for the Put you sold and let the Put you bought run until expiration, or for as long as the price of the stock continues to drop. This may result in an increase in the value of the Put you bought sufficient to offset the loss incurred when you bought back the Put you sold.

If you don't have enough time until expiration, buy-to-close the Put you sold and then sell the Put you originally purchased for whatever you can get for it. This results in the maximum loss for this trade.

Bear Call Spread

Just as the name implies, the Bear Call Spread can be a great strategy to employ when you believe that a stock is likely to remain neutral, or perhaps drop in price.

Background

Suppose you find an optionable stock with a sideways trend in a weaker industry group, or under weak market conditions. These factors may have a negative effect on the price of the stock. The plan for this trade is to sell Call options to someone right before the stock falls, making it unlikely for the options to be exercised. Since you're not certain that the stock will fall, you'll purchase a bit of insurance against the possibility of the stock rising in price.

Since you're bearish on the stock, you would likely first buy at least one Call option contract two strike prices above the current price of the stock for the current expiration month. As the option buyer, you would expect to pay the Ask price for the option. Next, you would sell at least one Call option one strike price above the current price of the stock for the same expiration month. This may actually be the at-the-money option, depending on the price of the underlying stock.

Case Study

Suppose the current price of the stock you're considering is $29.00 per share. In order to place a Bear Call Spread, you would first buy the $35.00 strike price Calls for an Ask price of $0.25 per share or $25 per contract. Next, sell the $30 strike price Calls for a Bid price of $1.00 per share.

Maximum Profit

After placing the two trades, the net credit to your account is $75 per contract. This is the maximum profit you can expect from this trade.

Maximum Loss

The worst-case scenario for this trade is for the stock to rise above the $30 strike price you sold. This could present a problem, as you don't currently own the stock. Suppose the stock were to rocket upward to $50 per share. You would be forced to go out and buy the stock for $50 per share...that is you would be forced to buy it at $50 per share if it weren't for the fact that you own the Call option, which gives you the right to buy the stock for $35 per share. The fact that you essentially bought insurance against the stock rising in price means that the most you could lose is the $5 per share difference in price, between the $35 per share you are forced to spend to buy the stock and the $30 per share you are able to make selling the stock to someone else. This $500 loss per contract is mitigated by the $75 per contract credit to your account when you first placed the trades. This limits your maximum loss to $425 per contract.

Maximum Return on Risked Capital

The maximum return on risked capital for this trade is calculated by taking the maximum potential profit for the trade ($0.75) divided by the maximum potential loss for the trade ($4.25), or $0.75/$4.25=0.176 or 17.6% potential return on risked capital. This maximum return on risked capital occurs in the event that the stock closes under the $30 strike price you sold.

At this point, the stock will move in one of three ways: up, down, or sideways. Here is how to handle each of these scenarios.

Stock Moved Down

If the stock price moves down below the strike price you sold, both the Call options expire worthless. Using the figures from the example above, if the stock closes below the $30 strike price you sold, both the $35 strike price options you bought and the $30 strike price options you sold expire worthless. You keep your $75-per-contract profit. Your potential return is 17.6%. No further action is required.

Stock Moves Up Slightly

In this scenario, the stock rises in price above the option that you sold. This requires that you place a buy-to-close order to remove your obligation on the contracts you sold. Using the example above, you would place a buy-to-close order for the $30 strike price Calls in order to avoid being called out. If the stock continues to increase in price, let the $35 Calls rise in value with the price of the stock. At the first sign of weakness in the stock, usually initiated by profit taking, you might sell the $35 strike price options in an effort to lock in your maximum profit.

Summary

A Bear Call Spread is generally a short-term trade, so you don't have a lot of time to sit and wait for a stock to head in the direction you are expecting. Exit the short side of the trade at the first sign of weakness to avoid being called out and being forced to buy the stock to cover the trade.

Once you have bought to close the short side of the spread, you can leave the long side open to increase in value as the stock continues to move higher. When executing this time of strategy, be sure to sell-to-close the long side options on or before expiration.