Recently I’ve been writing about option spreads. These are trades that involve more than one option component. Our first example was a bull put spread. The main component, or anchor, of that position was a put option on the S&P 500 index that we sold in order to collect money from someone who felt the need for protection. In effect, we insured someone else (the buyer of the put we sold) against an event that we felt would not occur. In this case that was a drop in the stock market of about 10% in a month. Next, to protect ourselves in case a really big market drop did happen, we bought some insurance of our own by purchasing a put option at a lower strike price.
By buying that second component, we offset a great deal of the risk on the trade.
Offsetting something undesirable about an option position is the rationale for all option spreads.
In another situation, we might buy put options if we felt that a stock would drop. Buying the put options instead of selling the stock short would allow us to profit if the anticipated drop occurred. But by using puts, our risk would be limited to the amount paid for the puts (rather than unlimited, as it would be if we sold the stock short).
In this situation, we could improve our position even further by adding an offset unit and turning this position into a spread.
Let’s look at the chart of Harley Davidson (HOG) as of July 23, 2015:
HOG had been in a downtrend for all of 2015. At $58.75, it had recently staged a rally into a supply zone and had a good chance of failing and dropping back to at least the previous low at $54.66.
There were put options available at the $60 strike price, expiring in November 2015, for about $4.25 per share. If HOG did drop down to $54.66 and it took a month or so to do it, those puts would increase in value to about $6.43 per share. This estimate comes from an option analysis program – it can’t be calculated by hand because it would take so long to do it that the options would have already expired. Options analysis tools come with most brokers’ option trading platforms.
If those puts did go up to $6.43 from the current $4.25, that $2.18 profit would represent a 51% return on investment in one month on a drop in the stock of just 7%.
Our plan would be to sell the options at a small loss if HOG surprised us and went up past its recent high at $ 59.61. In that case, the options would drop to around $3.38, a loss of $.89 per share. Again, this estimate pops out of our options analysis software. Since most analysis programs use the same formulas to calculate option prices, all would give about the same answer.
So, for each option contract covering 100 shares we’d have to lay out $425 in cash. We’d then look either for a $218 profit if HOG dropped to our target; or an $89 loss if it rallied through our stop-loss price, assuming that either eventuality happened within a month.
This is not bad, although the reward-to-risk ratio could be better. So far it was $218 / $89, or 2.4 to 1.
This trade could benefit from being turned into a spread. November puts at the $55 strike could be sold for $1.95. That sale would reduce our net cost from $425 to $230. The new combination would have a smaller loss in case we were stopped out with HOG at our $59.61 stop-loss price. The loss would now be just $33 because the $89 drop in value of our long puts would be largely offset by a $56 drop in our short puts (putting that $56 back into our pocket).
Our maximum gain with HOG at the $54.61 target would also be reduced. Although our long $60 puts would still have increased by $218, to $643 from $425; our short 55 puts would also have increased in value, from $195 to $321, an increase of $126. All in, the spread would make $218 on the long puts and give back $126 on the short puts for a net gain at the target of $92.
Puts alone: reward-to-risk ratio = $218 / $89 = 2.4
Put spread: reward-to-risk ratio = $92 / $33 = 2.8
The put spread paid better in reward-to-risk terms.
It follows that it would also pay better in absolute dollar terms, for a given number of dollars at risk. If we were willing to risk about $1,000 on either of these trades, then we would size our positions accordingly.
For the puts alone, $1,000 total risk divided by $89 risk per contract would allow for a position size of 11 contracts. If these paid off at $218 each, then the total profit would be 11 * $218 = $2398.
For the put spread, $1,000 total risk divided by $33 risk per contract would allow for a position size of 30 contracts. If these paid off at $92 each, then the total profit would be 30 * $92 = $2760.
Once again, by combining options we could end up with a trade that squeezed more profit out of a given amount of stock movement. It takes a bit more effort than just hitting the Buy and Sell buttons, but the payoff is well worth it. If you have an analytical mind set, like an engineer, accountant or programmer, then consider educating yourself on options. I know that you will find it rewarding.
For questions or comments on this article, contact us at help@trading academy.com.