Podcast for Tuesday: Option Spreads

Pete, April 29, 2008 @ 8:00PM ET | Link | RSS | Read via Email | 9 Comments  

In today’s podcast [DOWNLOAD MP3 FILE] we demonstrated how to swing trade with bull call spreads and bear put spreads to manage risk and increase returns.

Bull Call Spread: COF

We set up a bull call spread using Capital One Financial as a study case.

cof.gif

Strike Symbol Last Chg Bid Ask Vol Open Int
25 COFFE.X 27.1 0 27.8 28.9 10 841
30 COFFF.X 20 0 22.9 23.9 30 359
35 COFFG.X 19.5 0 18 19 20 1,224
40 COFFH.X 13.8 Up 4.20 13.7 14.3 550 1,855
45 COFFI.X 10.3 0 9.6 9.8 2 3,068
50 COFFJ.X 5.6 Down 0.60 5.7 5.9 59 18,026
55 COFFK.X 2.85 Down 0.25 2.85 2.95 406 8,929
60 COFFL.X 1.05 Down 0.15 1.1 1.2 448 9,286
65 COFFM.X 0.25 Down 0.10 0.25 0.4 35 5,754
70 COFFN.X 0.15 Up 0.05 0.05 0.15 10 2,596
75 COFFO.X 0.05 0 N/A 0.1 27 1,579
80 COFFP.X 0.05 0 N/A 0.05 2 1,151
85 COFFQ.X 0.05 0 N/A 0.05 0 854

COF, last at $53.67
Stop Loss at $43.95

Sell 1 June 55 Call @ $2.85 = $2.85 x 100 = $285.00 CREDIT
Buy 1 June 45 Call @ $9.80 = $9.80 x 100 = $980.00 DEBIT

Net Debit = $695.00 PER CALL
Max Profit = $55 - $45 = $10 x 100 = $1000 - $695 = $305/$695 = 43.88%

Bear Put Spread: POT

We set up a bear put spread using Potash Corp Saskatchewan as a study case.

pot.gif

Strike Symbol Last Chg Bid Ask Vol Open Int
65 PVZRM.X 0.05 0 N/A 0.15 20 432
70 PVZRN.X 0.1 0 N/A 0.15 19 131
75 PVZRO.X 0.05 0 N/A 0.15 26 295
80 PVZRP.X 0.15 0 N/A 0.15 1 183
85 PYPRQ.X 0.15 0 N/A 0.1 105 968
90 PYPRR.X 0.25 0 N/A 0.1 1 482
95 PYPRS.X 0.05 0 N/A 0.2 10 183
100 PYPRT.X 0.1 0 N/A 0.15 4 834
105 PYPRA.X 0.35 0 N/A 0.35 1,011 2,161
110 PYPRB.X 0.2 0 0.2 0.3 2 2,113
115 PYPRC.X 0.2 0 0.2 0.45 3 1,027
120 PYPRD.X 0.45 Up 0.10 0.4 0.65 9 1,078
125 PYPRE.X 0.55 0 0.65 0.8 80 3,280
130 PYPRF.X 1.1 Up 0.55 1 1.15 49 5,274
135 PYPRG.X 1.55 Up 0.50 1.45 1.7 102 1,601
140 PYPRH.X 2.35 Up 0.80 2 2.3 108 5,196
145 PYPRI.X 3 Up 0.95 2.85 3.1 235 1,959
150 PYPRJ.X 3.9 Up 1.30 3.7 4 587 3,004
155 PYPRK.X 5.09 Up 1.59 4.8 5.1 213 2,852
160 PYPRL.X 6.4 Up 1.70 6.2 6.5 185 1,254
165 PYPRM.X 8.28 Up 2.28 7.8 8 185 1,445
170 PYPRN.X 10 Up 2.30 9.6 9.9 237 2,128
175 PYPRO.X 12 Up 2.60 11.7 12 527 993
180 PYPRP.X 14.1 Up 2.90 14 14.3 316 1,476
185 PYPRU.X 17.2 Up 3.70 16.6 16.9 463 1,241
190 PYPRV.X 19.4 Up 3.58 19.4 19.7 258 924
195 PYPRW.X 22.7 Up 4.10 22.4 22.8 87 709
200 PYPRX.X 25.9 Up 4.58 25.7 26.1 109 1,494
210 PJNRB.X 32.7 Up 6.10 32.7 33.2 44 1,459
220 PJNRD.X 41.6 Up 9.00 40.5 41 27 763
230 PJNRF.X 42.09 0 48.7 49.3 2 161
240 PJNRH.X 54.6 Up 3.13 57.5 58 1 97
250 PJNRJ.X 64.1 Up 8.21 66.5 67.2 3 92
260 PJNRL.X 68.1 0 75.7 77.7 20 69
270 PJNRN.X 66.7 0 84.8 87.1 10 90
280 PJNRP.X 75.8 0 94.5 96.9 10 30
290 PJNRR.X 88.1 0 104.3 106.7 10 20
300 PJNRT.X 111.5 Up 14.90 114.2 116.6 29 20
310 PJNRU.X 113.1 0 124.3 126.6 10 10
320 PJNRV.X 131.8 Up 9.30 134.3 136.6 4 10

POT, last at $182.50
Stop Loss not known, use April 23, 2008 swing high = $215.97

Sell 1 June 180 PUT @ $14.00 = $14.00 x 100 = $1400.00 CREDIT
Buy 1 June 210 PUT @ $33.20 = $33.20 x 100 = $3320.00 DEBIT

Net Debit = $1920.00 PER PUT
Max Profit = $210 - $180 = $30 x 100 = $3000 - $1920 = $1080/$1920 = 56.25%

Charts of the Day

The following charts were mentioned in today’s podcast. As usual, we applied InVivo.RMI indicators (available as a bonus to Portfolio Strategy subscribers) to the daily chart along with the widely-watched 50- and 200-day moving averages. The pink/cyan dots provide potential entry/exit signals while the price bars are colored red/yellow/green to identify relative performance.

29-mon.gif

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  1. Frankie on April 30th, 2008 2:15 AM

    Good time for spreads, especially on financials, as the volatility will probably get sucked out of your trade after the FOMC tomorrow!

    But can I ask you a couple of questions? I am trying to understand your rationale for this COF trade. For example, you mentioned COF trades at 53.67 and your stop loss is 43.88. If it were to hit your stop loss tomorrow, all else being equal, you would theoretically take a $395 loss…which is more than your max $305 gain! So your risk/reward ratio is less than 1:1 and you need to be right about 60% of the time to break even (minus commissions), which is ok considering you have 68% probability of success. But your loss potentially increases as you move closer to expiration.

    So my first question is why would you place these trades now? How do you manage the risk in your spreads? Will you close it out early or is this trade offset by the POT bear put?

  2. Teresa on April 30th, 2008 2:17 AM

    We used COF as an example because many traders look will look at the chart and think that it is some sort of head and shoulders reversal.

    After the close, the stop was hiked to $46.28, but say the stop was still at $43.95. In order to be stopped out tomorrow, the stock would have to move down by nearly 18% from today’s close. That would be a very big day, probably triggered by some fundamental catalyst, in which case, you’d be happy you didn’t own the underlying.

    I personally would not place this trade because I don’t believe in “big game hunting” of breakouts. It’s not a setup in my book, but we needed an example of something that people do all the time. Traders should evaluate each spread to make sure it has a satisfactory payoff. And don’t forget, the trader’s stock picking skills contributes greatly to the long run results. I can’t do anything about that part.

  3. Daniel on April 30th, 2008 8:54 AM

    Thanks for the podcast.

    I have a question (clarification: I know nothing about options). If the price goes to your favor, are you able to make like a trailing stop as with stocks going short or long? or do you have to wait and that is all?

    Thanks Teresa and Pete

    P.S. Would you recommend other places to learn about options or is The Options Industry Council just a right starting point?

  4. Teresa on April 30th, 2008 10:15 AM

    You still need to pay attention to the stops and trail them up until the spread is well into the money.

    For example, with COF, if the stock price had closed below $43.95 yesterday, you would have liquidated the spread by buying back the June 55 and selling the June 45.

    The trailing stop for COF today is $46.28 (I use StopFactor 1.1 for swing trades) so if COF looks like it will *close* below $46.28, I would liquidate the spread near the close.

    We repeat this procedure until the spread reaches it’s maximum $10 profit.

  5. Teresa on April 30th, 2008 10:17 AM

    And yes, The Options Industry Council website is as good as any to start. Obviously they are there to stimulate the trading of options, but still, it is better than going to an unknown website.

    The best solution, of course, is to read John Hull’s Options, Futures, and Other Derivatives. It’s “the bible”.

  6. Peter on April 30th, 2008 10:40 AM

    Daniel

    You can also check out the CBOE website under the Strategies tab and then you can take a look at the Strategy Archive section. They provide some examples using options with different market situations. Obviously their bias is to have you trade options on their exchange.

  7. Daniel on April 30th, 2008 1:30 PM

    Teresa Pete,

    Thanks for all the learning, patience and dedication!

    As it seems (to me), this way you limit your profit but also your risk. Could be a good way to go into next earnings and avoid nasty reversals. Also Fed talks.

    The other thing I see good in it is that when shorting you can get called (since one borrows a stock) so although you may have wanted to continue with the position you are taken out from it.

    Let me know if my suppositions are correct, thanks once again,

    Daniel

  8. Teresa on May 1st, 2008 1:28 PM

    Rex was wondering why the put spread is slightly underwater even though POT is down. Here is the reason:

    Take a look at the 21-day historical volatility (Volatility Standard Deviation indicator in TradeStation 8.x). It has exploded over the past few days during the breakdown in POT.

    When volatility increases, the time premium portion of the option price also increases. Since the 180 put has a higher time premium component than the 210 put, the value of the put that we sold is temporarily worth more due to the expansion of the time premium.

    As POT continues downward AND/OR as time passes, the time premium on the 180 put sold will shrink. Any time the spread reaches the $10 maximum profit, the trader can liquidate it.

  9. Teresa on May 7th, 2008 10:36 AM

    Your observations are correct Daniel. Trading with laser precision can be difficult and stressful. Using the spreads, we take some pressure off.

    In the end, it’s not how much money we make: it’s how much we keep. A trader’s job is to manage risk and eek out the profits over time. I know this doesn’t sound sexy or exciting, but that’s how it’s done. :)