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No. of Recommendations: 1
I have done well selling naked puts, and I have begun to sell bull put spreads. Is there any good source to discuss the differences in using bull put spreads v. bull call spreads. I tend to like receiving the credit up front. The put spreads have margin requirements and have limited upside. I like receiving the credit on the credit spreads rather than the debit on the call spreads, but am I short changing my ultimate results.

If I was very bullish on a certain position, I could sell a put spread and buy a credit spread on the same position.

What are the thoughts of others on this?

Thanks,
Emmette
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I certainly would like to learn about option spreads - especially as a way of minimizing risk. Doe anyone have any 'real world' examples they would like to share?

LOL! I'm not looking for a stock tip, just want to study an example of a Bull Put Spread. Thanks in advance
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Credit put spreads and debit call spreads are two sides of the same coin. They have the same risk/reward. If the strikes are below the stock price, and you are right that the stock goes up in price at expiration, one benefit of the credit put spread is that the options will expire worthless without incurring a commission charge. In contrast, the debit call spread will require exercise commissions.

Alex Jacobson of the ISE prefers debit spreads because his experience is that they are slightly cheaper. The reason? Implied volatility tends to increase with lower strike prices as traders pay up for downside protection. Thus, credit put spreads usually have a negative volatility skew -- the put purchased has a higher implied volatility than the put sold. In contrast, debit call spreads sometimes have a positive volatility skew. See the following link for Jacobson's article on the subject:

http://iseoptions.com/pdf/Hidden_Costs_Of_Credit_Spreads.pdf

Tom Preston of thinkorswim is skeptical of this argument and says that you will likely find that the cheapest spread is the one composed of out-of-the-money options. Why? Because OTM options are more heavily traded, consequently are more liquid, and thus have tighter bid/ask spreads. In the case of a spread composed of strikes below the stock price, the OTM options will be the credit put spread, not the debit call spread.

What I personally do is price out both the credit spread and the debit spread and choose the cheaper one. If the spreads are equally priced, I'll go with the credit spread to avoid the exercise commission charges.

Jim



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Jim:

Thanks for your response and the link to Alex Jacobson's article.

Emmette
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thank you, Jim
...very interesting article, too
I'm printing it out to study & understand it
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<<just want to study an example of a Bull Put Spread.>>

I'm looking at Whole Foods (WFMI) right now for a bullish trade. This is a blue chip company that has declined in value to a support area in the low 40s. I could sell a May 45/40 put spread for $1.75 -- sell the 45 put for 2.95 and buy the 40 put for 1.20. Breakeven is 43.25. Risk is 3.25, which is the difference between the strikes minus the credit received (5.00-1.75).

The same trade would be to buy the May 40/45 call spread for 3.25 -- buy the 40 call for 6.85 and sell the 45 call for 3.60. Breakeven is 43.25. Risk is the price of the call spread of 3.25.

Profit potential is 1.75/3.25 = 53.8%

Jim


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Jim - thank you so much for sharing your knowledge.

I'm going to set up a spreadsheet for myself to detail the relationships you just explained for the example Bull Put & Bull Call Spreads - (that's the only way I can really understand and learn, it seems)
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I created a spreadsheet, using your helpful example. I think I understand the setup now.

It seems that at Breakeven Stock Price the Protective Put (purchased) is worth $0 and the Higher Strike Put (sold) is worth approximately the net credit received.

So, the Protective Put (purchased) only helps in the case of a big stock price crash? Of course, that's when protection is really needed.

Forgive me, if I'm thinking out loud here...
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<<So, the Protective Put (purchased) only helps in the case of a big stock price crash?>>

The purchased put limits your loss to the difference between the strike prices ($5). Limiting your loss helps you minimize your margin requirement and lets you put on a much larger position (and leverage) than would be possible if you simply sold a put.

It's ironic -- selling a put spread brings in a smaller premium than selling a put but ends up letting you make more money through leverage.

Jim

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It's ironic -- selling a put spread brings in a smaller premium than selling a put but ends up letting you make more money through leverage.


Hi Jim,
Now you have my attention. I never thought about this leverage issue with regard to spreads. I sold naked puts some time ago. It worked really well until that day it didn't. sigh
Thanks, Steve
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Hi, Jim - another question - I noticed in your example, you chose a MAY expiry. My understanding has been that it's better to take advantage of time decay one month out.

Were you just picking a random example, or is there a specific reason for going 3 months out from FEB expiry? thanks again
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It worked really well until that day it didn't.

This seems to be true of a lot of "easy" investment strategies.
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<<My understanding has been that it's better to take advantage of time decay one month out.>>

For covered calls, you are correct because all you are trying to do is bring in a little extra income to your existing stock position. The real risk of your position is not the option but the stock. The stock may decline but likely no more than 20%-30%.

However, the WFMI spread trade is a pure options position. If I am wrong on my bullish directional bias and the stock falls to $40 or below, I risk total loss (100%). In this case, I need a substantial reward-to-risk ratio to make it worth my while. Consequently, I am willing to trade off a longer time frame for a larger option premium. The March 45/40 put spread brought in a premium of only 1.25 whereas the May 45/40 brought in a premium of 1.75.

Could I sell the March put spread and then at March expiration roll over to the May put spread, just like I would do with a covered call? Yes, but since there is risk of total loss at March expiration, I don't want to.

There is no right or wrong answer to time frame; I'm just telling you my personal trading preferences.

Jim

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Jim thanks for the example. Could you explain why you chose those strike prices?

Lee


I'm looking at Whole Foods (WFMI) right now for a bullish trade. This is a blue chip company that has declined in value to a support area in the low 40s. I could sell a May 45/40 put spread for $1.75 -- sell the 45 put for 2.95 and buy the 40 put for 1.20. Breakeven is 43.25. Risk is 3.25, which is the difference between the strikes minus the credit received (5.00-1.75).

The same trade would be to buy the May 40/45 call spread for 3.25 -- buy the 40 call for 6.85 and sell the 45 call for 3.60. Breakeven is 43.25. Risk is the price of the call spread of 3.25.

Profit potential is 1.75/3.25 = 53.8%

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<<Could you explain why you chose those strike prices?>>

I want positive theta (i.e., position benefits from time decay), so the short put strike of my spread needs to be out-of-the-money (OTM). With WFMI trading at $45.50, the first OTM strike is $45.

I choose the first OTM strike, rather than a more distant OTM strike, because I want to bring in at least 40% of the distance between the strikes in premium. A 40% premium means that I have a 60% chance of making money. I like to keep my risk-reward ratio somewhere between 40%-60%. This allows me to win at least half the time and still bring in substantial premium. For more details on the probability of profit in option spreads, see my articles:

http://www.fool.com/investing/options/2006/10/24/be-your-own-casino-an-options-tutorial.aspx

http://www.fool.com/investing/options/2006/10/25/be-your-own-casino-part-2.aspx

Jim
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I am not sure if this is a good strategy for WFMI, because it is already beaten down, and seems to have formed a bottom, but in many cases where I am bullish on a stock I use a ratio back spread. I use this either when a stock has alreay appreciated a lot, so I am concerned with the risk of buying stock, or when it has gone down, but I am not ready to call a bottom yet (though in the case of a beaten down stock I often just sell a put, if I want to own the stock anyway).

I try to be delta neutral, and sell an in the money call and buy 2 or more at the money calls, aiming for a reasonable credit. This lets me profit if the stock goes up or is still on its way down. What do you think of this for WFMI?
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<<I use a ratio back spread.>>

George Fontanills of optionetics loves this trade, calling it his "vacation trade" because you don't need to monitor it on a daily basis. It involves selling an ITM call and buying two or more OTM calls. You make money when the stock goes up big and you don't lose money when the stock goes down big. The risk of the trade is that the stock doesn't make a big move. Maximum loss occurs at expiration if the stock closes on the strike of your long calls and then you can lose big. You also lose if the stock closes anywhere between the strike of the short call and a point slightly higher than the strike of the long calls.

http://biz.yahoo.com/opt/061227/opt_16387.html?.v=1

A ratio backspread is a type of "homerun" trade that makes big bucks if the stock makes a big move. But my experience is that homerun trades are low probability events that often result in time decay losses. Take, for example, the following trade:

Sell 1 WFMI May 45 call
Buy 2 WFMI May 50 calls

At May expiration, the trade loses money between 45.10 and 54.60. That looks like a big range to me. In contrast, a simple 45/50 call spread bought for 2.10 makes money at any point above 47.10. Of course, the vertical spread loses 100% below 45 whereas the ratio backspread loses nothing if the stock plummets.

Which trade is better? It really depends on where you think the stock is going to go. I personally like the vertical spread better because it requires a smaller move to make money and I don't like betting on extreme events.

Jim

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When I use this spread, I always look for a premium, so that I make money if the stock goes down, rather than breaking even. That also reduces range where I lose money.

I also tend to use it only when I am interested in stock that is appreciating rapidly, but that has already had a good run, so I consider there to be both a good chance of continued appreciation, and a risk of a big drop.

For instance, I have an Infosys backspread composed of:

Premium = -1 Call55 @$4.70 + 2 Call60 @$1.45 x 2 = $1.80

This loses money if Infy is between $57 and $63 - the maximum loss at $60 is $3.20.

At 55 or below, I have the maximum downside gain of $1.80. The maximum upside gain above $63 is unlimited.

I think it is an interesting strategy for growth stocks and momentum stocks. You are covered whether the growth continues, or you have a correction. If you don't want to cover downside risk, then I agree that a bull vertical spread might be better.
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<<You are covered whether the growth continues, or you have a correction.>>

I would just clarify that you are covered if BIG growth continues, or if you have a BIG correction.

Little moves are the enemy of this trade.

Jim

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It seems like everyday we see some stock gapping up by 10-20% on open. Maybe this would be the spread to try for these. The thing that would concern me is my fill could get out of whack. That is, the long end fill price could be out of balance with the short fill price. Does this happen in a fast moving market ? I ask because I have yet to try any spread.
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<<the long end fill price could be out of balance with the short fill price.>>

This is not a problem, provided that you always enter a spread order as a limit order. This ensures that you have time to calculate the fair value of the long option and the short option and only pay what the fair value of the spread actually is.
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