Option Spread Trading

The Smart Profits Report: Issue #330
Thursday, July 13, 2006

Option Spread Trading: How a Bear Spread Can Make You More Than One Put Options Trade
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Hang onto your hat, because we’re going to dive headlong into the low-risk, profitable world of option spread trading today - both bear spreads and bull spreads.

The mere mention of terms like these can intimidate some investors and dissuade them from making the trade. Don’t be one of them. You’d be missing out on a great, low-risk way to grab profits.

Today, let’s see how to add this lucrative technique to your trading arsenal…

Expensive Premiums? Option Spread Trading Is The Answer

Option spread trades are my favorite trades in circumstances where option premiums are very expensive. So when you’re caught in that position, here’s a way around it…

Say you have a security whose share price is $20. You think it’s headed down. The obvious choice is to buy a straight put option, with a $20 strike price. Assuming it’s a LEAPS option, with implied volatility priced in, the option would cost around $2.50. That means your break-even point would be $17.50 ($20 minus $2.50). The most you’d risk is the $2.50 premium.

While some investors might think that’s a pricey premium and walk away, you don’t have to be one of them. There’s another choice…

Assuming that you don’t think the shares will fall below $15 within your specified time frame, you could enter into a bear spread.

How to Execute a Bear Spread

Using a bear spread simply means you sell another put option at a lower strike price (in this case, $15) against the put option you bought. By doing so, you essentially enter a covered position. Let’s say the $15 put option is selling for $1.25 - the equation goes as follows:

You buy the $20 put option for $2.50 and you sell the $15 put option for $1.25. Your total risk has now dropped from the original $2.50 to $1.25 ($2.50 minus $1.25). The most you can make on this trade is $5 - the spread between $20 and $15.

Let’s say the shares of the security close at $15 by the time your options expire. Remember that in the first case, your put was for the $20 strike and cost you $2.50. Your breakeven was $17.50. So if you just bought the original put option, you’d make a profit of $2.50 - the difference between your break-even and $2.50 - or 100%.

But here’s how a bear spread could make you more…

With the spread, your cost was $1.25. If shares of the security close at $15, you’d make a $3.75 profit on the trade - 200% in total and 50% more than with the original put option trade. Bottom line: Your real return is higher, your percentage return is higher and your risk is 50% lower based on this scenario.

And don’t forget… Like all options trades, you can trade out of a spread by simply reversing your transaction. This way you can still capitalize on a downward move, even if it occurs earlier than expiration. It would still be profitable as long as the shares were moving down.

Bullish? Simply Reverse the Play - But Watch Your Ranges

Naturally, this type of spread trade works equally well if you’re bullish on a security, too. It’s called a bull spread. In this case, instead of buying a put option and selling another put option against it at a lower strike price, you’d simply buy a call option and then sell another call option against it at a higher strike price. Once again, you’d reduce your overall cost and risk, but you’d also limit your upside.

And because your upside is limited, make sure you pay attention to trading ranges. If you think shares of a certain security will be rangebound, a bull/bear spread is perfect. If, however, you think a security is going to shoot to the moon, or plunge into a sinkhole, you wouldn’t want to limit your upside. You’d play it another way, or engage in a wider spread.

While spreads can be quite complex, once you know what you’re doing, you can use them relatively easily and enjoy some healthy profits. However, some investors simply dismiss spreads because they don’t take the time to understand them - and sadly, that includes some brokers.

When Your Broker Won’t Let You Trade Option Spreads…

Here’s a situation that should never happen…

In my LEAPS Trader service a few weeks ago, I made the call that the Nasdaq was set for a drop. It was the right call at the right time, and using a bear spread on the Nasdaq QQQQ, readers were able to clean up with almost 70% profits in just a few weeks.

Shortly after we closed the trade, however, I received a letter from one of my members, telling me that his broker wouldn’t let him do the trade.

If your broker won’t allow you to execute a spread trade, don’t give him your business. Fire him. If you look at the dynamics of a spread trade, there’s no reason why you should not be allowed to do one. Why?

First, you’re actually reducing your risk by reducing the amount of money that you have at risk.
Second, the options on a spread move in tandem.

If you’re doing a bull spread, and the share price moves higher, the options you bought also increase in value, as well as the options you sold. In fact, the options you bought actually increase in value faster, since they’re closer to the money than the ones you sold - hence your risk decreases with every tick up.

As long as you’ve covered both sides of the trade, the broker is not at risk any more than he would be on any other covered trade. His only argument arises if he says: “What if you sell the initial option that you bought, but decide not to buy back the second half of the spread?”

Avoid Scaring Your Broker With Naked Options

In that case, you would now be “naked” - a situation that scares the heck out of most brokers. That’s because when you’re naked, you’re out in the open, with unlimited liability. You could lose some big bucks and your broker is on the hook for it. Simply put, this is a situation you want to avoid at all costs - and most brokers won’t take the risk here, either.

Fortunately, most brokers believe you will trade rationally and will simply ask you to put up more collateral in your account, to make sure you make good on your promises.

The point is this: My member’s unfortunate situation with his broker is avoidable. If you want to make money using one of the best options strategies around, you need to enable yourself to do so. Don’t miss out on a trade - and potential profits - simply because your broker says you can’t do it. That’s never going to make you wealthier.

Sure, your broker might sleep better, but all you’ll get is frustration, having been needlessly deprived of a powerful trading tool. If that applies to you, make the move and find a better broker today.

Good Trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

Immerse yourself in the art of the “spread.” Read more on this excellent, low-risk trading strategy and discover the anatomy of the perfect spread trade. It’s a tool that can make you a better, more successful trader… right now! See Smart Profits #216: Spread Trades & The Market Maker: Two Valuable Options Lessons from Boston.

As I said earlier, spreads work on the downside and the upside… See how you can use spreads to play both sides of the market in Smart Profits #151: Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth.