Bull Put Spreads - Controlled Risk/Return

Discussion in 'Options' started by rickf, Apr 7, 2007.

  1. rickf


    I've spent most of the past few evenings reading up on spreads, and my local Borders' is quite happy with my patronage...the Cohen books are rather well-written and easy to follow, explaining much to me. Also, this forum has also been a big help in getting some additional insights along the way, and I sincerely thank you all very much.

    I think my earlier confusion was thinking only of calls and not that you could use puts when feeling cautiously-bullish and/or want to generate some income at expiration time. After doing some reading, I went ahead and explored Bull Put Spreads:

    I ran a paper trade P&L on a Bull Put Spread on ABC:

    ABC trades at $18.05. I enter a Bull Put Spread for a 10-contract APR 12.5/17.5 spread -- buy the 12s, sell the 17s -- for $1.45 credit. (I use 10 contracts just for demonstration purposes since it's a nice round number.)

    This is what the brokerage system graph shows come expiration:

    Stock Price Profit/Loss
    $7.50 ($3,650)
    $10.00 ($3,650)
    $12.50 ($3,650)
    $15.00 ($1,150)
    $16.15 $0 ----------- BEP
    $17.50 $1,350
    $20.00 $1,350
    $22.50 $1,350

    As I understand it, as long as ABC doesn't go below my 16.15 BEP come expiration, I'm okay -- and if the underlying stock price is $17.50 or greater on expiration, I would earn $1350 as my 'capped' profit potential for the spread. (I also like that there's a cushion between the current stock price and the BEP, which is helpful to accomodate small near-term fluctuations in price.) Time decay isn't a factor per se since I'd be holding the contracts through expiration rather than selling them sooner. If so, this meets my desires to trade in a rather conservative manner that results in a lower-risk, lower-profit potential using Bull Put Spreads on positions I'm neutral-to-somewhat-bullish about.

    In general, as a sanity check, am I reading this correctly? While I've done rather well with basic calls/puts, I'm just trying to do my due diligence before jumping into even the most basic of spreads.

    Thanks again for the insights, and hope y'all are having a good weekend!
  2. IV of ABC must be > 100 to receive such a high premium...lemme guess ..DNDN ?
  3. rickf


    You got me. :) I had done so well with my DNDN long calls the last week that I am debating trying a basic spread out this time in a relatively low-risk manner. Obviously DNDN's IV is high as a kite, and its returns wouldn't be anywhere like it might be for a lower-IV range-bound position.

    Frankly, I just wanted to make sure my basic understanding of Bull Put Spreads was accurate and that setting up the spread with both strikes below the underlying's current price would be doable and potentially, albeit somewhat, profitable as long as the stock price stayed neutral or went higher by expiration.
  4. Tums


    one question you can explore:

    What happens to the IV (esp Put IV) when the market falls?
  5. u21c3f6


    Did you mean $1.35 credit?

    Using a probability calculator, there is a 90% chance that the stock price will touch $17.50 and only a 50% chance that it will close above $17.50. Do you have a plan for what to do if that happens? This appears to be very risky to me unless you have a very good reason to believe that it will not touch or close below $17.50.

  6. if your protective part of the spread is that low (12.5), you might as well just go naked w/ it.

    Unless the FDA rejects DNDN's prostate cancer drug, which is highly doubtful, I don't think that stock will see 12.5 ever again.
  7. rickf


    Yes, credit. Fat-fingered the original post.

    Risky in terms of early assignment on the put? Yes, that's sure a possibility. I'm not 100% set on that particular spread, but it seemed to give a fair degree of "wiggle room" just in case there was any downward-facing action between now and expiration, what with this being my first ultra-conservative forray into spreads.

    I've not gotten into much technical analysis yet, so the percentage probabilities you cite are interesting (perhaps reassuring if I went with a higher-strike spread) but probability estimates aren't something I've looked at yet. Definately something I should look into, though......if only there was a decent options-analysis/strategy program that ran on MacOSX. :(
  8. Tums


    this is from TOS. Their platform runs on MAC. At one time they give out a MAC mouse for signing up. Don't know if they still do that.

    <img src="http://www.elitetrader.com/vb/attachment.php?s=&postid=1427535">
  9. Tums


    Probability of Expiring

    <img src="http://www.elitetrader.com/vb/attachment.php?s=&postid=1427541">
  10. Tums


    Implied Volatilies

    <img src="http://www.elitetrader.com/vb/attachment.php?s=&postid=1427543">
    #10     Apr 7, 2007