Buy options with at least 60 days until expiration

Bear Put Spread Road Map

In order to place a bear put spread, the following guidelines should be observed:

1. Look for a bearish market where you anticipate a modest decrease in

the price of the underlying stock.

2. Check to see if this stock has options available.

3. Review put options premiums per expiration dates and strike prices.

Buy options with at least 60 days until expiration.

4. Investigate implied volatility values to see if the options are overpriced

or undervalued. These spreads are best placed when volatility is low. 5. Explore past price trends and liquidity by reviewing price and volume

charts over the past year. Look for chart patterns over the past one to three years to determine where you believe the stock should be by the date of expiration.

6. Choose a higher strike put to buy and a lower strike put to sell. Both

options must have the same expiration date. Determine the specific trade you want to place by calculating:

Limited Risk: The most that can be lost on the trade is the net

debit of the two option premiums.

Unlimited Reward: Calculated by subtracting the net debit from

the difference in strike prices times 100.

Breakeven: Calculated by subtracting the net debit (divided by

100) from the long strike price.

Return on Investment: Reward/risk ratio.

7. Create a risk profile for the trade to graphically determine the

trades feasibility. If the underlying stock increases or exceeds the price of the short put, the trade reaches its maximum risk (loss) potential. Conversely, if the price of the underlying stock decreases or falls below the strike price of the long put, the maximum reward is attained.

8. Write down the trade in your traders journal before placing the trade

with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

9. Make an exit plan before you place the trade.

Consider doing two contracts at once. Try to exit half the trade

when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk allowing it to accumulate a bigger profit. If the spread doubles, exit half of the position.

If you have only one contract, exit the remainder of the trade when

it is worth 80 percent of its maximum value.

Exit the trade prior to 30 days before expiration.

10. Contact your broker to buy and sell the chosen put options. Place the

trade as a limit order to limit the net debit of the trade. 11. Watch the market closely as it fluctuates. The profit on this strategy

is limiteda loss occurs if the underlying stock rises above breakeven point.

12.Choose an exit strategy based on the price movement of the underly-ing stock.

The underlying stock falls below the short strike: The short

put is assigned and you are obligated to purchase 100 shares (per option) of the underlying stock from the option holder at the short put strike price. By exercising the long put, you can turn around and sell the shares received from the option holder at the higher long put strike and pocket the differencethe maximum profit available.

The underlying stock falls below the breakeven, but not as

low as the short strike: Sell a put with the long put strike and buy a put with the short strike. There should be a small profit remaining.

The underlying stock remains above the breakeven, but be

low the long strike: Sell a put with the long strike and buy a put with the short strike, which will partially offset the initial debit or allow you to pocket a small profit; or wait until expiration and sell the long put to offset the trades net debit and let the short option expire worthless.

The underlying stock rises above the long option: Let the op

tions expire worthless, or sell the long put prior to expiration to mitigate some of the loss.

Bull Put Spread Road Map

In order to place a bull put spread, the following guidelines should be observed:

1. Look for a bullish market where you anticipate a modest increase in

the price of the underlying stock.

2. Check to see if this stock has options available.

3. Review put options premiums per expiration dates and strike prices. Look for combinations that produce high net credits. The Optionetics.com Platinum site allows for searches that will quickly qualify candidates for you. Since the maximum profit is limited to the net credit initially received, try to keep the net credit as high as possible to make the trade worthwhile.

4. Investigate implied volatility values to see if the options are over

priced or undervalued. Look for options with forward volatility skewswhere the higher strike option you are selling has higher IV than the lower strike option you are purchasing.

5.Explore past price trends and liquidity by reviewing price and volumecharts over the past year or two.

6. Choose a lower strike put to buy and a higher strike put to sell. Both

options must have the same expiration date. Keep the short strike atthe-money. Try to avoid selling an in-the-money put because it is already in danger of assignment.

7. Place bull put spreads using options with 45 days or less until expira

tion. Since the profit on this strategy depends on the options expiring worthless, it is best to use options with 45 days or less until expiration to put time decay on your side.

8. Determine the specific trade you want to place by calculating:

Limited Risk: The most you can lose is the difference between

strikes minus the net credit received times 100.

Limited Reward: The net credit received from placing the combi

nation position.

Breakeven: Calculated by subtracting the net credit from the short

put strike price. Make sure the breakeven is within the underlying stocks trading range.

Return on Investment: Reward/risk ratio.

9. Create a risk profile for the trade to graphically determine the

trades feasibility. The diagram will show a limited profit above the upside breakeven and a limited loss below the downside breakeven. In the best scenario, the underlying stock moves above the higher strike price by expiration and the short options expire worthless.

10. Write down the trade in your traders journal before placing the trade

with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

11. Make an exit plan before you place the trade.

Consider doing two contracts at once. Try to exit half the trade when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk, allowing it to accumulate a bigger profit.

If you have only one contract, exit the remainder of the trade when

it is worth 80 percent of the maximum possible value of the spread. The reason for this rule is that it usually takes a very long time to see the last 20 percent of value in a profitable vertical spread. Its better to take the trade off and look for new trades where the money can be put to better use.

12. Contact your broker to buy and sell the chosen put options. Place the

trade as a limit order so that you maximize the net credit of the trade. 13. Watch the market closely as it fluctuates. The profit on this strategy is

limiteda loss occurs if the underlying stock falls below the breakeven point.

14.Choose an exit strategy based on the price movement of the underly-ing stock:

The underlying stock rises above the short strike: Options

expire worthless and you keep the initial credit received (maximum profit).

The underlying stock rises above the breakeven, but not

as high as the short strike: The short put is assigned and you are then obligated to purchase 100 shares from the option holder of the underlying stock at the short strike price. You can either keep the shares in hopes of a reversal or sell them at the current price for a small loss, which is not completely balanced out by the initial credit received. To bring in additional money, sell the long put.

The underlying stock remains below the breakeven, but

above the long strike: The short put is assigned and you are then obligated to purchase 100 shares of the underlying stock from the option holder at the short strike price. You can either keep the shares in hopes of a reversal or sell them at the current price for a small loss, which is not completely balanced out by the initial credit received. To mitigate this loss, sell the long put.

The underlying stock falls below the long option: The short

put is assigned and you are then obligated to purchase 100 shares of the underlying stock from the option holder at the short strike price. By exercising the long put, you can sell these shares at the long strike price. This loss is partially mitigated by the initial credit received and results in the trades maximum loss.

3. Review call options premiums per expiration dates and strike prices.

Look for combinations that produce high net credits. The Optionetics.com Platinum site allows for searches that will quickly qualify promising candidates for you. Since the maximum profit is limited to the net credit initially received, keep the net credit as high as possible to make the trade worthwhile.

4. Investigate implied volatility values to see if the options are over

priced or undervalued. Look for options with a reverse volatility skewlower strike options have higher implied volatility and higher strike options have lower implied volatility.

5.Explore past price trends and liquidity by reviewing price and volumecharts over the past year or two.

6. Choose a higher strike call to buy and a lower strike call to sell. Both

options must have the same expiration date. Place bear call spreads using options with 45 days or less until expiration.

7. Determine the specific trade you want to place by calculating:

Limited Risk: The most you can lose is the difference in strike

prices minus the net credit times 100.

Limited Reward: The maximum reward is the net credit received

from placing the combination position.

Breakeven: Lowest strike price plus net credit received

Return on Investment: Reward/risk ratio.

8. Create a risk profile for the trade to graphically determine the trades

feasibility. The risk graph of a bear call spread slants downward from left to right, displaying its bearish bias. If the underlying stock falls to or past the price of the short put, the trade reaches its maximum profit potential. Conversely, if the price of the underlying stock rises to or exceeds the strike price of the long put, the maximum limited loss occurs. 9. Write down the trade in your traders journal before placing the trade

with your broker to minimize mistakes made in placing the order and to keep a record of the trade.

10.Make an exit plan before you place the trade.

Consider doing two contracts at once. Try to exit half the trade

when the value of the trade has doubled or when enough profit exists to cover the cost of the double contracts. Then the other trade will be virtually a free trade and you can take more of a risk, allowing it to accumulate a bigger profit.

If you have only one contract, exit the remainder of the trade when

it is worth 80 percent of its maximum value.

11. Contact your broker to buy and sell the chosen call options. Place the

trade as a limit order so that you maximize the net credit of the trade. 12. Watch the market closely as it fluctuates. The profit on this strategy is

limiteda loss occurs if the underlying stock rises above the breakeven point.

13.Choose an exit strategy based on the price movement of the underly-ing stock:

The underlying stock falls below the short strike: Let the op

tions expire worthless to make the maximum profit (the initial credit received).

The underlying stock falls below the breakeven, but not as

low as the short strike: The short call is assigned and you are then obligated to deliver 100 shares of the underlying stock to the option holder at the short strike by purchasing these shares at the current price. The loss is offset by the initial credit received. By selling the long call, you can bring in an additional small profit.

The underlying stock remains above the breakeven, but be

low the long strike: The short call is assigned and you are then obligated to deliver 100 shares of the underlying stock to the option holder at the short strike price by purchasing these shares at the current price. This loss is mitigated by the initial credit received. Sell the long call for additional money to mitigate the loss.

The underlying stock rises above the long option: The

short call is assigned and you are then obligated to deliver 100 shares of the underlying stock to the option holder at the short strike. By exercising the long call, you can turn around and buy those shares at the long call strike price regardless of how high the underlying stock has risen. This limits your loss to the maximum of the trade. The loss is partially mitigated by the initial credit received on the trade.

CONCLUSION

The four vertical spreads covered in this chapterbull call spread, bear put spread, bull put spread, and bear call spreadare probably the most basic option strategies used in todays markets. Since they offer limited risk and limited profit, close attention needs to be paid to the risk-to-reward ratio. Never take the risk unless you know its worth it! Each of these strategies can be implemented in any market for a fraction of the cost of buying or selling the underlying instruments straight out.

In general, vertical spreads combine long and short options with the same expiration date but different strike prices. Vertical trading criteria include the following steps:

1. Look for a market where you anticipate a moderately directional

move up or down.

2. For debit spreads, buy and sell options with at least 60 days until expi

ration. For credit spreads, buy and sell options with less than 45 days until expiration.

3. No adjustments can be made to increase profits once the trade is

placed.

4. Exit strategy: Look for 50 percent profit or get out before a 50 percent

loss.

In general, volatility increases the chance of a vertical spread making a profit. By watching for an increase in volatility, you can locate trending directional markets. In addition, it can often be more profitable to have your options exercised if youre in-the-money than simply exiting the trade. This isnt something you really have any control over, but it is important to be aware of any technique for increasing your profits.

These strategies can be applied in any market as long as you understand the advantage each strategy offers. However, learning to assess markets and forecast future movement is essential to applying the right strategy. Its the same as using the right tool for the right job; the right tool gets the job done efficiently and effectively. Each of the vertical spreads has its niche of advantage. Many times, price will be the deciding factor once you have discovered a directional trend.

The best way to learn how these strategies react to market movement is to experience them by paper trading markets that seem promising. You can use quotes from The Wall Street Journal or surf the Internet to a number of sites including www.cboe.com (for delayed quotes) or www. optionetics.com. Once you have initiated a paper trade, follow it each day to learn how market forces affect these kinds of limited risk strategies.

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Previous Issues

200809-26

We realize that options do not trade at just one price

200809-25

This is a credit trade when initiated and makes money when the market closes below the strike of the short option

200809-24

In order to choose the options with the best probability of profitability for a credit spreadbull put and bear call spreadsit is important to balance out five factors

200809-23

Both options must expire in the same month

200809-22

A variety of options strategies can be employed to hedge risk and leverage capital

200809-21

Review options premiums with various expiration dates and strike

200809-20

Check to see if this stock has liquid options available