In last week’s article about a bullish put spread, I described a way to use options to be in the insurance business while eliminating part of the risk involved. Today I want to talk about a couple of other aspects of that trade.
This is an example of the use of option spreads. An option spread is any position that consists of two or more components where at least one of those is an option. A covered call is a type of spread with a long stock position paired with a short call. The bull put spread I described last week is another type, made up of one short put and one long put.
Spreads are very useful in many situations. In any spread one part of the position is designed to make money. This component is called the anchor of the position. The anchor can be long or short stock, a long or short put, or a long or short call.
The anchor by itself is not a spread. Alone it would be called a single-leg position. What turns the anchor into a spread is the addition of an offsetting unit. That offset is added to the anchor to reduce something that is undesirable about the anchor on its own. That unit, too, could be short or long stock, a short or long put, or a short or long call. Any of the various permutations is possible.
In the bull put spread example, the anchor of the position was a short put at the 1970 strike on the S&P 500 Index. Selling this put short would bring in money – $2065 to be exact. All of that money would be ours to keep as long as the index remained above 1970 (it was at 2070 at the time).
An undesirable thing about that anchor was that it had unlimited risk. If the index dropped below 1970, we would be on the hook for $100 for every additional point it dropped until the options expired.
Another undesirable thing about that short 1970 put was the amount of capital that had to be tied up in it. That would have been $197,000 in a cash account, or about 20% of that in a margin account
To this anchor we added an offset in the form of a long put at the 1950 strike. In effect, we re-insured the insurance that we had sold. Now if the index should drop below 1970, although we were still liable for $100 a point from 1970 on down, we would begin collecting $100 a point on our long 1950 put once the index dropped below that 1950 strike. So, at worst we might have to lay out $100 times twenty points (the difference between 1970 and 1950). Our worst-case liability was now $2,000.
So the undesirable characteristic of unlimited risk had been eliminated; and since the capital required for an option trade is based on the worst-case scenario, which was now a $2,000 liability, only $2,000 in capital would be needed for this trade. That meant the associated undesirable attribute of tying up $197,000 in cash had also been reduced to just $2,000.
This massive reduction in risk came at a cost. Options are the ultimate balancing act. In this case buying that 1950 put cost us $1,710 out of the $2,065 that we had received for the short 1970 put, leaving us with a net credit of $355. This amount was now our maximum profit. This amount would be subtracted from our maximum liability of $2,000, leaving us with $1645 of our own money at risk.
Was the trade-off worthwhile? We had given up $1710 out of $2065, or 83% of our maximum profit. But we had reduced the maximum risk and capital required from $197,000 to $1,645 – a reduction of more than 99%. The spread position retained 17% of the potential profit, but only 1% of the cost. For most people that would be a good trade.
This spread was selected because a) we were bullish on the index and b) the amount of money that we could get for selling the puts was high. It is just one of many spreads that can be put together to match up with different market outlooks. In future articles we’ll look at some of the other possibilities.
The key to making any option trade work is being able to have a confident opinion about the direction of the stock. We use the patented Online Trading Academy Core Strategy for that. If you haven’t learned the Core Strategy, contact your local center and sign up for our three-day Market Timing class.
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