By buying a “higher strike” put option, you gain the “right” to sell shares of an underlying at a given price and by selling a “lower strike” put option; you undertake an “obligation” to accept (buy) those same shares at a lower price.  This is very similar to shorting stock, where you sell shares at a higher price and then buy them back a lower price, booking the difference as a profit.  Therefore, the most you can make on a bear (long) put spread is the difference between the two strikes.   Maximum Value of Spread = Difference between Strike Prices

By combining a long put option with a short put option, you will be able to create a bear put spread, also referred to as a long (buying) put spread.  This type of spread is placed for a debit, thus the term “long” put spread.  Take a look at the risk profile below for further clarification:

Now that you understand how a bear put spread functions, let’s look at an example.  Let’s say that you are bearish on Research in Motion (RIMM) and after looking at RIMMs option chain, you decide that buying a straight put is too expensive (65 strike would cost $1.97), thus you decide to buy a put spread instead.  Your expectation is that RIMM will drop to $60 within the next 5 weeks, so you decide to buy a 65 put and sell a 60 put simultaneously, creating a bear (long) put spread.

The 65 put will cost a debit of $1.97, while the 60 put will bring in a credit of $0.94.  Combining the two put options together would create a bear put spread, which would cost a net debit of $1.03.  Since the spread can be worth only $5 (difference between strikes), the most you could make on this trade would be $5 – $1.03 = $3.97, at expiration.

Basically, you would be risking a debit of $1.03 (max loss) to make $3.97 (max profit).  Max. Risk (Loss) = Debit Paid

Max. Profit = Difference between Strike Prices – Debit Paid

Before placing this type of trade, you must analyze the likelihood of RIMM dropping all the way from $72 to $60.  Otherwise, you could always analyze the 70/65 put spread, which would cost you a net debit of $1.89.  Trading options is all about balancing your risk with the expected reward and your analysis of the underlying stock.

The 65/60 bear put spread would breakeven once the debit paid ($1.03) to enter the trade is recovered.  In this case, your breakeven would be $65 – $1.03 = $63.97.  At expiration, RIMM would have to drop to $63.97 before the 65/60 put spread would start to make money.

Breakeven = Long Put Strike – Debit Paid to enter spread

Now that we know how a bear put spread functions, let’s look at the several advantages of this strategy:

• Lower cost than buying a straight puts because you are also selling an option
• Spread can be morphed into other advanced strategies

The risk profile of a bull put spread is the same as that of a bull call spread because the idea behind the trade is the same – it’s a bullish trade.  However, the fundamental difference is that a bull put spread is a credit spread, meaning that you will receive a credit for placing the trade, while a bull call spread is a debit spread, where you must pay a debit to enter the trade.  Therefore, a bull put spread is also called a short put spread.

So what does it mean to trade a bull put spread?  To answer this question, let’s breakdown the individual components of the trade and analyze them individually.  By selling a put option, you are taking on the obligation to accept shares of an underlying at a given strike price.  If you are unclear about selling put options, refer to the basics once again.  With a short put option position, as the underlying drops in price, the put option gains in value, leading to a loss.  This loss is unlimited because the underlying can keep dropping!!  To protect against this loss, a lower strike put option is purchased – creating a bull put spread!!

The lower strike put option limits the risk introduced by the sale of a higher strike put.  This is the basic explanation behind the workings of a bull put spread!!  Here is the risk profile for a sample bull put spread trade:

Let’s say that you are bullish on Apple (AAPL) and after looking at AAPL’s option chain below you decide to sell a put spread.  You may be tempted to sell a put option by itself, but remember the unlimited risk issue!!  With AAPL at $212, you are of the opinion that the stock will reach $220 within the next 4 weeks. 

To take advantage of this move, you sell the 220 strike because as the stock moves up in price, the value of the 220 put option will decrease.  Then to limit your downside risk, you purchase a lower strike put option.  In this case, let’s look at the 210 put strike.  By putting the two together, you have just created a bull put spread!!

By selling a 220 put strike option, you receive a credit of $10.05 and the 210 strike put strike would cost you a debit of $3.15.  That leaves you with a net credit of $6.90 [$10.05-$3.15].  You can keep this amount as long as AAPL reaches $220 by expiration.  The amount of credit received is the maximum amount of profit you can make on this type of trade!!  And since this spread can only be worth $10, the difference between the two strikes (220-210); the maximum risk on this trade is the difference between the spread amount and the max. profit [$10 - $6.90 = $3.10].

Max Profit = Credit Received

Max. Risk (Loss) = Difference between Strike Prices – Credit Received

Once the max. risk is determined, the breakeven point for a bull put spread is just the lower put strike plus the amount of risk.  In this case, the breakeven would be $210 + $3.10 or $213.90.  Apple would have to reach this point by expiration in order for you to breakeven on the trade.

Breakeven = Long Put Strike + Max. Risk

1. Buy put options to protect their stocks holding (refer to the guidebook #1 for more information on this topic)
2. Close the position
3. Adjust the position

An investors’ reaction in this type of situation primarily depends on his/her investment style.  If you are risk averse, you may end up closing the position, but if you are somewhat optimistic, you may adjust your position.  However, before you make any decision, be sure to analyze your positional risk.  When panic sets in, even savvy investors can lose sight of their goal and close positions that end up being profitable.  Of course, we always have the benefit of hindsight.  However, as investors we must try to make an informed decision based on our risk tolerance and view of the market.  Let’s take a look the 1^st reaction listed above and closely analyze the factors that one must consider.

When a drop of this magnitude occurs, implied volatility rises, meaning that the market expects large price swings.  To account for these swings, the market marks-up the price of options.  This means that the time value or “extrinsic value” in an option becomes inflated and buyers end up paying more for options.  Also, the fact that people are rushing to buy put options also inflates their price to a certain extent because there is increased demand.  One way to counter the possible increase in volatility is to buy put spreads instead of put options.  Also, put spreads are cheaper in general than standalone put options because you end up buying an option and simultaneously selling another option. 

By buying a put spread, you are buying volatility at a high level and also selling volatility near the same level.  The two options counter each other and protect you from paying too much for the implied volatility built into the option price.  However, the one drawback of a put spread is that it gives you limited protection.  For example, if you own AAPL at $200 and buy a 190/180 put spread, you will have downside protection that starts at $190 and ends at $180, which is only $10 worth of protection.  Whereas, a 190 put option would have given you unlimited downside protection starting at $190, but you would end up paying a lot more in option premium to buy the 190 put option. 

These are some of the things that  you must consider before taking any action related to buying put protection for your portfolio.  Be sure to signup for the exclusive guidebook as it will walk you through protecting your portfolio from the time you initiate your position.

The most basic “bear call spread” is placed when the underlying (i.e. stock) is above both the call strikes, making it an ITM spread.  A trader buys a “higher” call strike and pays a debit and concurrently sells a lower call strike and receives a larger credit.  Combining the two, the short call spread end up being placed for a “credit”.  Take a look at the option chain below, along with the AAPL exmaple to understand this concept.

For example, let’s say that you form a bearish opinion on AAPL (Apple Inc.), currently trading at $210, and decide to place a bear call spread.  To enter the trade, you buy a higher call  strike (200) and sell a lower call  strike (195).  For the long 200 call you pay a debit of $11.20, but receive a credit of $15.70 for the short 195 call.  This is the entire concept behind a bear call spread, where the option you sell more than covers for the one you buy because its further ITM than the one you buy.  Thus, the trade is placed for a credit.  In AAPL’s case, you would receive a credit of $4.50.

As APPL stock moves lower, both the call option will lose value and when it passes the short strike by expiration, both call options will contain no “real” value and you will get to keep the entire premium of $4.50.

The maximum profit on a Bear Call Spread is the “credit” received and in this case, the maximum you can make is $4.50 given that AAPL closes below the short strike of 195 by expiration.  Once you know the max. profit, the maximum risk is just the total value of the spread minus the credit received.

Max Profit = Credit Received

Max. Risk = Difference between strikes – Credit Received

The breakeven point on bear call spread (short call spread) is calculated by adding the premium received (credit) to the short call strike.  For AAPL, the breakeven point would be $195+$4.50 = $199.50.  So by expiration, AAPL must be trading below $199.50 for you to make money, but it must close below $195 if you want to keep the entire credit.

Breakeven = Short Call Strike + Credit Received

By buying a “lower strike” call option, you gain the “right” to purchase shares at a given price and by selling a “higher strike” call option; you undertake an “obligation” to deliver (sell) those same shares at a higher price.  For example, by simultaneously buying a 40 call strike and selling a 45 call strike, you have just gained the right to purchase shares at $40 and taken on the obligation to sell them at $45.  Therefore, the most you can make or the bull call spread can be worth is $5, the difference between the two strikes!!

Maximum Value of Spread = Difference between the Strike Prices

By combining a long call option with a short call option, we are able to create a bull call spread, also referred to as a long (buying) call spread.  Take a look at the risk profile below for further clarification:

Now that we understand how a bull call spread functions, let’s look at a current example.  Let’s say that you are bullish on Google (GOOG) and after looking at GOOG’s option chain below you decide that a straight call is too expensive.  For a 640 call you would be paying a debit of $17.10 or $1710.  With Google at $627, you decide that a 640/650 call spread would work best with over a month remaining until expiration.

The 640 call could be bought for $17.10, while the 650 call could be sold for $13.00.  Combining the two call options together would create a bull call spread, which would cost a total debit of $4.10 or $410.  Since the spread can be worth only $10 (difference between strikes), the most you could make on this trade would be $10 – $4.10 = $5.90, at expiration.

Basically, you would be risking a debit of $4.10 (max loss) to make $5.90 (max profit).  Max. Risk (Loss) = Debit Paid

Max. Profit = Difference between Strike Prices – Debit Paid

The bull call spread would breakeven once the debit paid ($4.10) to enter the trade is recovered.  In this case, your breakeven would be $640 + $4.10 or $644.10.  Google would have to reach this point in order for you to breakeven on the trade.

Breakeven = Long Call Strike + Debit Paid to enter spread

Now that we know how a bull call spread functions, let’s look at the several advantages of this strategy:

• Lower cost than buying a straight call because you are also selling an option
• Spread can be morphed into other advanced strategies

I personally trade vertical spreads more often than straight calls and puts because they offer numerous advantages like the ones listed above.  The next vertical spread we will cover is the bear call spread.

To clear up any misconceptions, let’s explore the top 5 option trading myths and discuss the realities:

To counter these two areas (cost of option and unlimited risk of short options), one could use vertical spreads.  A vertical spread is a combination of two options (same type) with different strikes expiring in the same month.  The 4 basic vertical spreads are as follows:

Each of the four spreads described above has limited risk exposure and reward potential.  Additionally, spreads can be traded for a lower cost than straight calls and puts.  In trading vertical spreads, we give up some profit potential to limit our risk exposure and this trade-off is critical in options trading because managing RISK is everything!!

Spreads also form the foundation for all other advanced option trading strategies and I personally use vertical spreads on a daily basis.  As a start, click here to read about how the the bull call spread functions.

Top Reasons

1. Buy Options TOO Far OTM:  When you do this, you are throwing away your money!!  OTM options are so cheap because they have a very small probability of making money by the time expiration rolls around.  If the underlying only moves by $5 a month, then you shouldn’t be buying options that are $20 or even $15 OTM.
2. Get Rid of Winners & Keep Losers:  Traders who are new to options/stock trading tend to hold onto loosing position too long, thinking that things will turn around.  Sometimes that may happen, but most of the time they don’t and the trader ends up taking a bigger loss.  On the other hand, when a position shows a hint of profit, traders tend to pulls the trigger too soon and close the position.  Large losses coupled with small profits are not a good combination and this is why you need a trading plan with entry and exit criteria.
3. Take on RISKY Positions:  When you only sell call or put options, you are exposing yourself to unlimited risk.  Selling options to bring in premium (credit) may work for 1, 2 or even 3 months, but the day the market reverses course, your position could be heavily underwater with large losses.  So DON’T expose yourself to unlimited risk.  Use advanced techniques such as vertical spreads, etc to always cover your positional risk.
4. Bad Adjustments:  There is NO free lunch in trading!!  When you start to adjust your position into something else by buying or selling more options, you are exposing yourself to additional risk.  Your adjustment make work or may not, but make sure that you understand you positional risk after any adjustment so there are no surprises!!
5. Lack of Education:  Before you even think about trading, make sure that you understand the basics.  Then, I would suggest that you open a brokerage account and paper trade with virtual money to see how options trading works and how your trading decisions pan out.  This will help you get a feel for options trading!!

Happy Trading!!

All of us have received a “HOT” stock tip from our friends, relatives or siblings at some point and probably have acted upon it by buying shares of that particular stock.  Years ago (Jan 06), I came across a wireless device distributor called Brightpoint Inc. (CELL) that was suppose to “blow-up” in the next few weeks.  Either I could buy stock and HOPE that it goes up or I could buy options and limit my risk.

To minimize my risk on this highly speculative play, I decided to buy options instead of stock.  With CELL at $18, I bought both a call and a put option to take advantage of a stock move in either direction.  Over the next few weeks, CELL jumped to ~$26 and went onto make a high before reversing and dropping to $11.  I was able to profit from this speculative play with a very small investment.  However, if I would have bought stock at $18, I would seen a significant decline in my investment had I not sold it around its high of >$30 because the stock dropped drastically from that point within a few months.

Options allow you to speculate without heaving to take a major risk as the capital investment is low, but the upside benefits are the same as if you would have bought stock.  Options (long calls) limit your downside risk, but allow you to participate in the rally.

Review Options Trading Benefit #1 – Minimum Capital or Option Trading Benefit #2 – Protecting Your Investment.

Here is a brief summary of my experience with the various brokerages!!

ETrade:  Offers many portfolio management tools and allows you to trade a variety of investment products (i.e. bonds, futures, stock, options, etc).  Commissions are on the high side and their options trading platform is very basic – no risk profile!!

Interactive Brokers:  Offers the lowest commissions of any broker, but their trading platform is not very user friendly.  They charge a small fee if you call into the trade desk to place/cancel an order or if you cancel an order yourself on the trading platform.  On the upside, they allow you to trade a variety of investment products.  No risk profile for options!!

Trade King:  Offers low commissions when compared to other brokers and allow you to trade a variety of investment products (i.e. Stocks, options, ETFs, bonds, etc.).  Have great support and you can call-in to the trade desk to place orders without incurring heavy charges.  The options trading platform has a lot of features, including risk profile!!

Thinkorswim (TOS):  The commissions are a bit on the high side, but still lower than ETrade and can be negotiated with the right approach.  Their trading platform is made for options traders and you can also trade stocks, bonds, FX (currency trading), etc.  The options trading platform is “feature” rich and you can call into their trade desk to discuss you trade with an actual broker.  No charge for canceling or modifying orders.

Disclaimer:  I use TOS for my own personal trading and at the time this post was published, I had no relationship/affiliation with the brokerage firm.