by Chris Rowe 08/29/08
EXAMPLE NO.1: SELLING A VERTICAL PUT SPREAD
Let's look at selling a vertical put spread for $2. When you enter a spread, you only enter one price: the amount that you intend to pay or receive. However, to break down the mechanics behind the trade, I'll explain it using two prices separately.
Just as we did in our example above, we would sell the March 170 Put for $7. (This is "leg 1," where we collect a credit for the option sale.)
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Then, we would buy the March 165 Put, which is trading at $5. (This is "leg 2," where we pay a debit to "Buy to Open" this portion of the spread.)
Keep in mind, you don't have to sell at the bid price and buy at the asking price -- you can fish for a better price. (For example, you can enter a spread order to get in for a credit of $2, or the difference between the money we collect for the short leg and the money we pay for the long one.)
This is called a bull-put spread or a put credit spread. No matter what you call it, you are collecting more money than you spend to enter the trade.
Since we received $7 and spent $5, we have collected a total net credit of $2.
Here, our breakeven point is $168. With OIH trading anywhere above $168, you're profitable.
Our maximum downside risk (as long as you close out the position before expiration day) is $300 per contract. So if we sold one March 170, and bought one March 165 against it in the same transaction, I'd consider that one contract.
If you do this, the risk is $300. So, why risk $300 to make $200? Because the odds of success increase tremendously when you profit from time passing, and your breakeven point is lower than the securities price.
If you are highly confident that the security will do what you think it should, I'd recommend structuring the spread with two options that have strike prices close to the price of the underlying security's price. This may be because there is a good risk-versus-reward picture in the security itself due to it being near some vital support level, like if it corrected back to its uptrend line or is bouncing off of historically potent horizontal support.
Margin requirement: The potential loss. This is the difference between the strike prices minus the premium received. Because the risk here is $300, that's your margin requirement.
Insurance of owning a put with the next lower strike price: When you think about it, what happens if OIH trades all the way down to $10? You sold the March 170 Put for $7, which obligates you to buy OIH at $170 ($10 higher than$160). If you simply sold that put naked (uncovered), your loss (if you only sold one put for $700) would be $153 (or, $160 - $7).However, since this is a vertical spread, you also own the March 165 Put, meaning that someone else is obligated to buy OIH from you for $165 if you choose to exercise your right as an option buyer.
So, per both contracts (your short March 170 and your long March 165), you would technically have to buy OIH for $170, and then sell it for $165 -- a $5 loss.
Since you received $2 for the vertical spread, you would only lose $3. (If your broker is half-decent, you wouldn't have to put up the cash to actually buy OIH for $170 and sell it at $165. Be sure to ask.)
So, Bill, if you're interested in leverage with less risk (and less reward) than a naked put, instead of selling one naked put on OIH with a requirement of $3,250, you can sell the vertical spread x 11 with a requirement of $3,300 ($300 margin requirement x 13). In this case, you take in a premium of $2,600 instead of the $700 that you'd get from a naked put spread.
Michael Shulman
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