Put Spreads

In my last options posting, I talked about call spreads. Put spreads are remarkably similar except that you are expecting a downturn in that underlying security. Put spreads, like call spreads, minimize the risk to the investor, because they allow your initial investment to be reduced. Note here that it is important to always use the same expiration date on both the put that you buy to open and the put that you sell to open.
So the put spread is buying a put close to the money (or in the money) and selling a put further away from the money.
For example:
I have been watching another stock that is currently trading at $82.65, up a $1.50 on Friday. It is somewhat near the high end of it’s 52 week high/low. I am considering buying a put spread on this stock. The JAN $80 put is selling for $2.10. The JAN $75 put is selling for $0.80. So if I were to buy into this trade, it would cost me a total of $1.30 per share. So for my 10 contracts, it would cost me $2,100 ($2.10 x 100 shares per contract x 10 contracts) for the JAN $80s. I would then receive $800 back ($0.80 x 100 x 10) for the JAN $75s. So the total cost to enter the trade would be $2,100 - $800 for a grand total of $1,300 plus commissions. This is also my total risk. In this case as with buying call spreads, the maximum that I can lose is the amount that I invest.
If the stock goes to $77 at expiration:
my $80 put is worth $3 per share x 100 shares x 10 contracts for a total of $3,000. The $75 put expires worthless. You might be asking why the $80 put is worth $3? Again a put allows me to sell the stock at a certain price on or before a certain date. So what is the ability to sell a stock at $80 worth if I can buy the stock on the market at $77? Three dollars. So all in all, I sell the JAN $80s and buy back the JAN $75 for the $3,000. I subtract the $1,300 that I paid to get into the trade, and I am now at my profit of $1,700.
If the stock goes to $72 at expiration:
my $80 put is worth $8,000. I could sell the put for that. However, the put that I sold initially, JAN $75, is now worth $3,000. So my total take is $5,000 - $1,300 to get into the trade, for my profit of $3,700.
If the stock goes to $80 or higher at expiration:
Both puts expire worthless, and I lose my entire $1,300.
So again the bottom line is, I am willing to risk up to $1.50 to make $3.50. In this case, the trade is even better because I am only risking $1.30 to possibly make $3.70.
Why I Like Spreads?
The biggest reason that I recommend spreads is because it allows smart investors like me to invest in closer to the money markets for a reduced amount. The underlying stock does not have to move as much in order for me to make a profit, and if the stock moves the other way, I lose less money.
The Risks?
The stock moving in the other direction and potentially higher commission rates because of more contracts being traded are the two that come to mind. For me, the upsides are better than the downsides, and that is why I trade them.
What is Left?
I could type an article every day for a year and would not cover all there is to know about options, picking stock candidates, and everything else involved. Stay tuned; I do plan on getting into some trades that will make money as long as the stock moves in either direction. If these topics interest you, sign up to receive Jeffry’s RSS feed. Until next time…