'Spread' Your Wings

'Spread' Your Wings
by Dawn Pennington 09/17/08

You can buy the bear-put spread by buying the put options at the $25 strike and then selling the $22.50 puts against them. Let's say you spend four bucks on the long $25 puts and collect three bucks on the short $22.50 puts. Essentially, it's the same strategy with the same expenditure, but it's a bet on the stock trading in a different direction!

Again, with the bear-put spread, you expect the stock to finish somewhere in the middle of the two strike prices. If the stock drops like a rock in a pond, the most you can make is the difference between the two strike prices, which is $2.50 ($25 - $22.50).

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So if you bet correctly and the stock goes down to, or through, $22.50, then your spread is worth $2.50. Remember, you've spent $1 to initiate this trade, so this could translate into a 150% gain, as you put a dollar on the table and you can cash out with an extra $1.50 in your pocket on top of your original investment.

You can establish bull-call and bear-put spreads in most trading and retirement accounts because the combination of a long and short option in a simultaneous transaction carries a similarly low amount of risk as just buying puts or calls.

When unwinding a spread position, you just reverse the orders that you give your broker. The long option that you "bought to open," you will now "sell to close." And with the short option that you "sold to open," you will now "buy to close."

As you can see, you can spend a little less money to make the same types of trades you might already be making. These less-expensive trades may come at the price of capping your upside, but the tradeoff can be worth it if you don't lose your shirt completely on a bet that doesn't turn out in your favor.