| Home | My photos | Forex | My trading | Contacts |
|
|
You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
|
Both options must expire in the same monthBull Call Spread Case Study A bull call spread is used when a trader is moderately bullish on a stock or index. By using a spread, the up-front cost to enter the trade is lower, but the offset is that the maximum reward is limited. Even so, when we expect to sell a stock at a given price anyway, it makes sense to lower the cost and thereby limit the risk to a manageable amount. A bull call spread consists of buying a call and selling a higher strike call. The sale of the higher strike call brings in premium to offset the cost of buying the lower strike call. What we then have is a limited risk, limited reward strategy. On October 24, 2003, the Semiconductor HOLDRS (SMH) put in a bottom formation. This was a good time to enter a bull call spread on SMH shares, looking for about a 6-point move in the shares. As of the close on this day, SMH shares were priced at $38.55. The January 40 calls could be purchased for $2.05 and the January 45 call could be sold for $0.50. This left us with a debit of $1.55 a contract to enter a bull call spread. The risk graph for this trade is shown in Figure 5.2. When trading a bull call spread, its best to see a 2-to-1 reward-to-risk ratio. This trade meets this qualification. The maximum reward is calculated by subtracting the net debit (1.55) from the difference between strikes (45 - 40 = 5) and then multiplying this number by 100. Thus, the maximum reward on this trade is $345: (5 - 1.55) 100 = $345. By enter ing five contracts, this trade would have cost $775, with a maximum reward of $1,725. The breakeven point is found by adding the net debit to the lower strike price. In this case, the breakeven is 41.55: (40 + 1.55 = 41.55). The risk graph of this trade is shown in On November 7, 2003, shares of SMH closed at $43.99 after trading slightly higher during the session. Since $44 was our price target, we could have sold on this day for nearly a 100 percent profit. The January 40 call could be sold for $5.30 and the January 45 call could be purchased back for $2.40. This equates to credit of $2.90 a share, but we then need to subtract the initial debit of $1.55. Thus, our total profit was $135 a contract, or $675 overall. Though buying a call outright would have created a larger profit, the risk also would have been greater. If SMH shares had fallen lower following the entry into this trade, a bull call spread would have seen a much smaller loss than a straight call. Bull Call Spread Case Study Strategy: With the security trading at $38.55 a share on October 24, 2003, buy 5 January 40 calls @ 2.05 and sell 5 January 45 calls @ .50 on Semiconductor HOLDRS (SMH). Market Opportunity: Expect a move higher in shares following a bounce from support. Maximum Risk: Limited to initial net debit of $775: [(2.05 - .50) 5] 100. Maximum Profit: (Difference in strikes - net debit) 100. In this example, the maximum profit is $1,725 and the actual realized profit is $675. Breakeven: Lower strike + net debit paid. In this case, the breakeven is 41.55: (40 + 1.55). BEAR PUT SPREAD A bear put spread, or long put spread, is a debit spread that is created by purchasing a put with a higher strike price and selling a put with a lower strike price. Both options must expire in the same month. This is a bearish strategy and should be implemented when you expect the market to close below the strike price of the short put optionthe point of maximum reward (at expiration). This high-leverage strategy works over a limited range of stock and futures prices. Your profit on this strategy can increase by as much as 1 point for each 1-point decrease in the price of the underlying asset. Once again, the total investment is usually far less than that required to short sell the stock. The bear put spread has both limited profit potential and limited upside risk. Puts with the shortest time left to expiration usually provide the most leverage, but also reduce the time frame you have for the market to move to the maximum reward strike price. The maximum risk of a bear put spread is limited to the net debit of the trade. The maximum profit depends on the difference in strike prices minus the net debit. It is important to find a combination of options that provides a high enough profit-to-risk ratio to make the spread worthwhile. Bear Put Spread Mechanics With XYZ currently trading at $56, lets create a bull put spread by going long 1 XYZ September 55 Put @ 2 and short 1 XYZ September 50 Put @ .50. The difference between the long 55 put premium of 2 ($200) and the credit received for the short 50 put (.50 or $50) is a net debit of $150. The net debit is the maximum risk for a bear put spread. The maximum reward for the trade is calculated by subtracting the net debit paid from the difference between strike prices: (55 - 50) - 1.50 100 = $350. Even though the reward is limited to $350, the sale of the 50 put has lowered the breakeven on this position. The breakeven occurs when the underlying assets price equals the higher strike price minus the net debit. In this case, the breakeven would be 53.50: (55 - 1.50 = 53.50). The risk graph for this trade is shown in Figure 5.3. The risk profile (see Figure 5.3) of a bear put spread slants upward from right to left, displaying its bearish bias. Once the underlying stock falls to the price of the short put, the trade reaches its maximum profit potential. Conversely, if the price of the underlying stock rises to the strike price of the long put, you will lose the maximum limited amount. Once again, it is important to monitor this trade for a reversal or a breakout to avoid losing the maximum amount. Exiting the Trade To exit a bear put spread, you have to monitor the daily price movement of the underlying stock and the fluctuating options premiums. Lets explore what you can do to profit on a bear put spread if one of the following scenarios occurs. Bear Put Spread Strategy: Buy a higher strike put and sell a lower strike put with the same expiration date. Market Opportunity: Look for a bearish market where you anticipate a modest decrease in the price of the underlying asset below the strike price of the short put option. Maximum Risk: Limited to the net debit paid. Maximum Profit: Limited. (Difference in strike prices - net debit) 100. Breakeven: Higher put strike price - net debit paid. Margin: Required. Amount subject to brokers discretion. XYZ falls below the short strike (50): The short put is assigned and you are obligated to purchase 100 shares of XYZ from the option holder at $50 a share. By exercising the long put, you can turn around and sell those shares at $55 a share and pocket the difference of $500. By subtracting the cost of the trade ($150), the profit on the spread is $350the maximum profit available. XYZ falls below the breakeven (53.50), but not as low as the short strike (50): Offset the trade by selling a 55 put at a profit and buying a 50 put at a loss, pocketing a small profit. XYZ remains above the breakeven (53.50), but below the long strike (55): Sell a 55 put at a profit and buy a 50 put at a loss, pocketing a small profit, or wait until expiration and sell the long put at a slight profit to offset the trades net debit and let the short option expire worthless. XYZ rises above the long strike (55): Let the options expire worthless, or sell the 55 put at expiration to mitigate some of the loss. Bear Put Spread Case Study A bear put spread is used when a trader is moderately bearish on a stock or index. By using a spread, the up-front cost to enter the trade is lower, but the offset is that the maximum reward is also lower. Even so, when we expect to cover short stock at a given price anyway, it makes sense to lower our cost. A bear put spread consists of buying a put and selling a lower strike put. The sale of the lower strike put brings in premium to offset the cost of buying the higher strike put. What we then have is a limited risk, limited reward strategy. On June 5, 2003, shares of Cigna (CI) were showing bearish tendencies. The stock closed the session on June 5 at $52 and a trader might have anticipated a move lower to support near $40. The move was expected to occur within the next few months, so a trader could have used the October options. By purchasing a 50 put and selling a 40 put, the trader would have entered a bear put spread for a total of $3.05 per contract. The long put would have cost $4.00 and the short put could have been sold for $0.95. In this case, lets assume the trader decides to place a trade for five bull call spreads. The risk graph for this trade is shown in Figure 5.4. Just like a bull call spread, we want to see a reward-to-risk ratio of at least 2-to-1. For this trade, the maximum risk is the initial debit of $305, or $1,525 for 5 contracts. The maximum reward is calculated by subtracting Bear Put Spread Case Study Strategy: With the security trading at $41.04 a share on June 5, 2003, buy 5 October 50 puts @ 4.00 and sell 5 October 40 puts @ .95 on Cigna (CI). Market Opportunity: Expect a moderate decline in the price of the underlying stock. Maximum Risk: Limited to initial net debit. In this case, $1,525: [5 (4 - .95)] 100. Maximum Profit: (Difference in strikes - net debit) 100. In this exam ple, the maximum risk is $3,475 and the actual realized profit is $1,875. Breakeven: Upper strike minus the net debit paid. In this case, the breakeven is 46.95: (50 - 3.05). the debit (3.05) from the difference in strike prices (50 - 40 = 10). Thus, the maximum reward of this trade is $695: (10 - 3.05) 100 = $695 per contract, or $3,475 for all five contracts. This creates a reward-to-risk ratio of 2.28 to 1 (6.95/3.05). On July 15, 2003, shares of CI closed at $41.04, leaving this trade with a very nice gain. Though the price target of $40 hadnt quite been reached, the trade was up more than 100 percent and this would have been a good time to take profits. The October 50 put could be sold for $9.50 and the October 40 put could be purchased back for $2.70. This equates to a credit of $6.80 a share, but we then need to subtract out the initial debit of $3.05. Thus, our total profit was $3.75 a share, $375 a contract, and $1,875 for all five contractsa gain of 123 percent. Though buying a put outright would have created a larger profit, the risk also would have been greater. If CI shares had risen following the entry into this trade, a bear put spread would have seen a much smaller loss than a straight put. |
|
|||||||||||||||
Previous Issues
|
| ©2007 Olesia | Home • My photos • Forex • News • My trading • Contacts |