Spread Option Plays

Session 1 – Introduction to Spreads

Spreads are designed to capture a set amount of premium between two strike prices. You are selling the higher strike price taking in cash; then you will buy a lower strike price spending cash; the difference is the profit potential at expiration. Typically, you will only buy one strike below your sold one to create a five-dollar spread. Your goal is to keep the difference between the two strikes if the trade works according to plan. Your average return on investment is 35%-50%.

There are several types to choose from like Bull Put Spreads, Bull Call Spreads, Bear Put Spreads, Bear Call Spreads, Butterfly Spreads, Strangle, Straddle, and Calendar Spreads.

A great benefit of spreads is that you can take advantage of selling naked without the major risks or requirements from brokers. Brokers will let just about anybody do spreads since your liability is capped when you buy the underlying strike.

The nice thing about these is you can maintain a predictable return each month. I concentrate on only two types of spreads: Bull Put Spreads/Bull Call Spreads and Bear Call Spreads/ Bear Put Spreads. I find these the easiest to manage and they bring in consistent profits.

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Session 2 – Bull Put Spreads

This is for those stocks you are bullish on. When you put on a Bull Put Spread what you are attempting to do is capture the premium between the strike prices you have selected. These are best done in lots of 10 or 20 contracts to get the maximum impact and market makers like it when you do 20.

Lets do an example to see how it works. I like to choose a stock that has a predictable pattern to it, (see charting for details.) Pick one that likes to trade to the upside and is moving higher. I like to see it take out an old resistance level on strong volume or make a clear bounce of a strong support level before I do these. I also like to do these about three weeks out before expiration to capture the maximum premium or the week of to capture a tiny scalp.

Session 3 – The Example

Lets take a look at an old favorite stock of mine, Broadvision (BVSN). On 5/26/00 BVSN bounced clearly off support at $30 and moved higher. On this day you would look to open the position by selling the June $35 puts and then buying the June 30 puts. For your efforts you would take in around $3 ½ dollars per contract on the sold puts and you would of spent around $1 ½ dollars on the bought puts leaving you with a potential profit of $2 dollars per contract.

Now your total commitment for this trade is the difference in strike prices (35 sold -- 30 bought = $5) less what you took in ($2) so your total risk is $3 dollars on 10 contracts or $3,000. If the stock closes above $35 by expiration you keep the $2,000 you took in and your risk is eliminated. It’s as simple as that.

Ok I know what you are thinking -- where is the downside right? Of course there is always one of those, but here is where things shine on this technique. If you were to just sell naked puts then you would be open to unlimited downside risk as the stock falls. If the stock got put to you then you would have to buy it at the price you agreed to and that could be disastrous if you did this on a big inflated Internet type stock.

So to protect yourself you would buy the puts one strike below the sold ones. If the stock plummets then your bought puts increase in value paying for your sold ones. If the stock gets put to you then you just put it to somebody else and your risk is eliminated and you still profit.

The key to this type of strategy is to make good entries so you do not have to worry about the downside. Be patient and do your due diligence before you pull the trigger.

Session 4 – Tweaks

Now here are a couple of tweaks that can substantially increase your percentage of returns. If you are approved for selling naked puts then you could leg into the trade. You would sell the puts in the morning and wait for the stock to increase in value and then buy your second leg of the puts considerably cheaper giving you a bigger spread to capture. This type of tweak can increase your profits by as much at 25%. Of course these tweaks take a watchful eye and are not for everyone. I like to stick to stocks that are currently moving up along with the market so I do not have to watch it so closely and can just keep my premiums I take in.

Session 5 – Pitfalls

Do not get greedy or impatient and chase these trades. Make sure you enter them early on breakouts or bounces of support. If you try to put them on when the stock has made its big move you could run into trouble. If the stock stalls and sticks between your two strike prices you could eat away at your premium and even lose money due to the time decay. If you get stuck in the middle then your total loss is the difference between what you took in and what you spent. In this case it would be $3,000.00 dollars, which is still a lot less risk than just selling puts and the trade goes bad. Been there done that -- gag!

Session 6 – Exits

Once a stock has climbed considerably above your spread then consider buying back the sold position and move on to the next trade as time decay and a rising stock price have shrunk the premium on the sold puts. I would not hesitate to spend a couple of hundred dollars and move on than think I have a sure thing and see it fall into my spread on expiration week. If I bought back the sold puts I would welcome the fall as my bought puts would now increase in value and I could sell them to bring in more profits!

If the stock starts to fall but manages to stick between your spread then you have to make a decision. There are factors to consider before you pull the trigger. Like, how much time is left to expiration? How far into the spread am I? What is the overall condition of the market and my stock? These simple questions will aid in your decision to massage the trade for a smaller profit or just cut and run.

There are a few things to consider when you un-lock a spread. These are the cost of commissions, lost money and profits. Your ability to un-lock a spread is directly tied to your ability to watch the market on a daily basis. It is safer to make your entries timed properly than try to un-lock a spread you think is going bad. Too many times I have seen this happen where the stock actually rebounded and it would have been a profitable trade if you just left it alone. So when you try to do these tweaks you have to have a watchful eye and be there every day. Otherwise you could make the trade go bad and wind up losing money. Remember -- entry is key… exit is everything!

Session 7 – Bear Call Spread

Bear call spreads are the same technique in reverse. These are good to do on stocks that have failed to take out known resistance level. You would sell the lower strike price at the failed high and then buy the higher one for protection. The goal is for the stock to fall below the strike you sold allowing you to keep the premium you took in less the money you spent for your long calls.

Bear call spreads off you the benefits of shorting stock without the negative effects. Once again your upside is capped as well as your downside. These can make great predictable returns month after month.

Let me offer a word of caution on this type strategy. When a stock is falling in price everybody is trying to prop it up. CEO’s will come out on CNBC and pump the stock and analysts will do the same. These require a little more monitoring but can prove to be just a profitable as Bull Put Spreads. Lastly I would emphasize you make proper entries on these and DO NOT CHASE THEM!

Session 8 – Example

On 6/2/00 Home Depot (HD) gapped open to $52.75 then rallied to $54, which is known resistance for this stock. It failed to rise above this and the next day started to slide. Here is where you would execute this strategy. You would sell the June 50 calls then buy the June 55 calls. Your approximate profit on this spread would be $3.50 per contract. The goal is for HD to stay below $50 by June expiration to keep the premium. From the looks of things Home Depot is going to do just that.

Now here is what I mean about time decay. Its 6/12/00 and expiration is Friday. The 50’s are at 3/8 ask and the 55’s are at 0 so your total cost to exit this spread would be $380 on 10 contracts. What should you do? I would spend the money and if HD were to somehow come out with some stellar news before Friday and pop up, my bought 55 calls might just become worth something and I could sell them and increase my profits.

Its amazing how many people will not give back some of the premium they took in and walk away with a nice profit. They get greedy and often times a stock will pop up and close in their spread taking more of their profit than the amount they would of spent exiting the trade in the first place. Do not get caught in the trap of being greedy. You know that is how they built those big hotels in Las Vegas. People just do not know when to quite when they have a profit.

Session 9 – The Outcome

Ok it’s 6/16/00 expiration Friday. Now if you take a look at a chart you will see exactly what I meant when I said, spending a little money will save you a lot of heartache. Home Depot actually popped up on 6/13/00 $3.38 and closed at $49.38 per share.

It hit a high of $49.69, which was just under our $50 sold price. Now here is where you get into a little trouble if you are not willing to spend a little money to move onto the next trade. The stock actually popped up to $51 on 6/14/00 then traded flat at $51 on 6/15/00 but then on expiration Friday, it closed at $49.81.

Now it did close below $50 however, there is still a risk that the stock could of got put to you since computers are doing the match ups automatically. When you are within $.50 cents you do run the risk of having some or all of the stock put to you. This is why I say it’s always good to spend a little bit of money towards the end when time decay has wiped out most of that premium and move on to the next trade with your profits in tact.

Profits Up!

The donFranko

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