From the December 01, 2011 issue of Futures Magazine • Subscribe!

Going vertical with debit spreads

Bearish scenario

A bear put spread (bearish vertical debit spread) involves buying a put option and selling a lower strike put. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The most the option trader can lose is the cost of the spread.

It’s Oct. 25 and ZZZ stock is trading at $318.50 a share. An option trader believes the stock is overbought and might decline over the next month. The options are pretty expensive, and the trader worries that the stock might keep rising, so a bear put spread makes sense. The trader can buy the November 315 put (just OTM) with a current delta of 0.44 for $9 and sell the OTM November 305 put with a current delta of 0.28 for $5.25. The cost of the spread is $3.75 ($9 – $5.25), which is the most the trader can lose if the stock finishes above $315 by November expiration (see "Bear put debit spread," below).

The maximum profit potential on the trade is $6.25 ($10 - $3.75), which is the difference in the strikes minus the cost of the trade. This would be achieved if ZZZ finished below $305 at November expiration. Breakeven on this trade can be calculated by subtracting the cost of the trade from the long put’s strike price. In this example, it’s $311.25 ($315 - $3.75) at November expiration. Just like what was shown in the bullish example, if the November 315 put were bought on its own, the breakeven on the trade would be $306 ($315 - $9), which is quite a bit more.

Currently, the delta on the spread is 0.16 (0.44 - 0.28), which means the trade will make or lose 16¢ for every dollar the stock goes up or down. Again, this can be a disadvantage, but if the stock rallies even more, which was one of the concerns, the trader will lose less on the spread than by just being long the puts.

The maximum profit goal of the bear put spread is to have the stock trading below the sold put’s strike at November expiration.

Vertical debit spreads are a relatively easy to understand and pretty straightforward option strategy. Just like any other option strategy, each has advantages and disadvantages. When deciding whether to buy just calls or puts, or to buy a vertical debit spread, the pros and cons of each have to be debated. Often, however, this analysis will come down on the side of the spread. With this strategy in your arsenal, you now can be prepared for those times.

John Kmiecik has worked for several firms, including Goldman Sachs and First Options of Chicago, and has traded professionally for hedge funds. Currently, he is an options coach for Market Taker Mentoring LLC. E-mail him at john@markettaker.com.

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About the Author

John Kmiecik has worked for several firms, including Goldman Sachs and First Options of Chicago, and has traded professionally for hedge funds. Currently, he is an options coach for Market Taker Mentoring LLC. E-mail him at john@markettaker.com.

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