I don't get bull put spread risk/reward

Discussion in 'Options' started by Robwynge, Mar 20, 2011.

  1. Robwynge

    Robwynge

    Hey guys,

    I am new to options and I'm finding myself mystified by something. I keep reading how a great way to make income in a bull market is by selling puts. I get that selling naked puts is somewhat risky (though not obvious that it's any more risky than just owning shares outright), so if I want to cap my risk, a bull put spread is the way to go.

    HOWEVER, every trade I try to set up in Thinkorswim shows a max loss that exceeds the max profit. Coming from the stock/futures world, regularly taking trades with unfavorable R/R is a cardinal sin. Here is an example:

    Sell April 145 puts for $18.20
    Buy April 140 puts for $17.00

    Max profit = $1,200
    Max loss = $3,800

    That's a 1/3 risk rward! I can widen the spread to up my reward, but obviously that ups my risk too.

    The only way this strategy could have a positive expectancy is to have a huge win rate, which I suppose may be possible with deep OTM puts, but still.

    Does anyone trade these regularly? If so, could you kindly explain if I am missing something here? How do people make this work?

    Thanks!

    -Rob
     
  2. is that 145/140 OTM or ATM? If it's OTM then yeah the risk will be larger. If you are sure it's a raging bull, ATM would be better R:R.
     
  3. Robwynge

    Robwynge

    That's out of the money. In fact, it's based on what I typed into Thinkorswim a couple of hours ago, so it's 30 or so SPX points OTM. Yes, closer to the money and the R:R is higher (though risk still exceeds reward), but then the odds of a winning trade are lower.

    I would think to make this strategy work, I would need to be pretty far out of the money so that I rarely took a loss. In fact, if I go far enough OTM, like to a 1200/1980 vertical put spread, it would seem almost like free money 99+% of the time (in a bull market). Of course, my R:R at that point is something like 1:9, so that means I would probably need to buy back before the strike was hit to avoid taking the full loss. Do people have strategies like that?

    Thanks!
     
  4. spindr0

    spindr0

     

  5. Yes, people have strats like that, but you are just selling black swan insurance. You are Allstate selling insurance for Hurricane Andrew. Thing is, you don't know if you are selling that policy in 1975 or in the summer of 1992 right before the storm came. With the geopolitical stuff going on, I wouldn't venture that far out. Stick to ATM stuff and get some type of directional edge.

    If you sell 1200/1980 hoping it doesn't get hit, just don't do it. Save yourself the stress.
     
  6. Robwynge

    Robwynge

    Thanks for the reply. I get the analogy, but black swans are black swans, if things are bad enough to take out 1200/1980, they take out ATM put spreads way sooner. At least with far OTM, there is time to bail out before you have to take the full loss.

    I usually swing trade stocks and futures, so I actually think I have a directional edge with a R:R that involves reward exceeding risk. If I really felt good about a trade, I would think it makes more sense to just buy the underlying and set a reasonable stop (if any options junkies want to explain why that thinking is wrong, I'd be glad to listen). The idea for OTM options is for extra income or as a back-up plan when I feel less certain about direction.

    In fact, because the R:R are skewed toward higher risk than reward, it's hard for me to get comfortable with the idea unless I was pretty damn sure the trade would work the vast majority of the time.
     
  7. drcha

    drcha

    Rob,

    I do not think you are missing anything. All such positions have an expectancy of around zero at the time you put them on. You have to guess the direction right, or at least, not be too wrong. These spreads accomplish two things for you: provide some leverage if you are right about the direction, and provide just a little protection if you are wrong about it. But you are absolutely correct that if you dial up the risk/reward, the probability will do the opposite thing. That is the nature of bull spreads, and of all other option positions, too.
     
  8. Robwynge

    Robwynge

    Ok, I think I get it. My current trading strategy is similiar to the Turtles strategy - I try to ride big trends (though my entry signals are different). This means I win small, lose small, or breakeven on 95% of my trades, and then 5% are huge winners that pay for the losers and then some (none of these are systems tested, just rough figures). With an OTM spread, I will basically have 95% small winners and 5% big losers. If the system has a directional edge, the winners will be small but add up to pay for the losers.

    If this trade off is theoretically correct, I suppose the issue of which system to trade becomes one of preference, no? (Though I could explore a combination of both strategies once I have this figured out better).

    Thanks again for all the replies thus far!
     
  9. donnap

    donnap

    Yes it does make sense to trade the UL if you're not liking the spreads.

    Obviously, you can get a more favorable R:R by selling ITM puts. Some option traders would look to the equivalent OTM bull call spread rather than ITM puts.
     
    #10     Mar 20, 2011