Followup on DOTM bull call spread and DITM bull put spread

Thanks so much, Kenneth.  In fact, I don't believe we truly are on opposite sides of the discussion; I believe, rather, that our methodology or understanding or practice may differ.  My position (opinion) remains as it was all along: that OTM bull call strategies are the opposite of ITM bull put strategies, both from the point of view of debit vs. credit, and the deltas being positive vs negative, respectively.  Now, to address some participants' assertion that they are "the same," because they complement each other (call delta 0.01 vs. put delta -0.99=1) is not what my argument is all about.  My position has been all along that in an OTM bull call spread with a tiny delta, the underlying stock would have to make an enormous move to the upside for that delta to respond, and for the spread to increase in price, and therefore be favorable to the buyer; while a similar enormous move to the upside on the ITM put spread would substantially decrease the cost of the put spread in favor of the seller, because of the delta near -1, that implies an almost 1:1 move of the options in relation to a move in the stock.  Both positions are bullish.  The call spread costs very little to enter, true, but would require too high a move to be influenced positively; while the opposite is true for the put. 

Whether my understanding of deltas (and thetas, in this case because of the very short expiry) is supported by the other participants in this debate is irrelevant.  This has been a hypothetical position all along, as I repeat, I would never select a front-month expiry for such positions, and I almost never, ever buy OTM calls.  My own methodology, if I wish to buy calls, especially OTM calls, would be to go very far off into the future to allow them time to fulfill their promise.  I'm generous that way.  As stated previously, my own preference in regards to puts is to do OTM naked puts or bull put spreads, but OTM (at a price less than the current stock price).

My hypothetical positions on AAPL, the subject of this debate, have been placed as a virtual trade on a great new platform that is currently a private beta, going public in the near future (preferred browsers include Chrome/Safari/Firefox).  To see my two spreads dance to the music in real time, please click on http://www.tradeclique.com/trader/yaelt#yael.

Another reminder of my preferences is that I generally do not wait for expiration.  I got burned badly in the 1999-2000 dot.com.  Whether it costs more or less in commissions is irrelevant to my peace of mind.  In the hypothetical ITM bull put spread above, since it was placed with a view that AAPL would make a substantial move to the upside by the Sep. 12 unveiling of a new iPhone, my preference would be to close down my put spread as soon as it presented a "significant" profit. I put that in quotations because I cannot tell you what I would consider significant, as to time to expiry is so short.  However, again, hypothetically, since I received a credit of $1800 for this trade, I might consider buying it back to close at, say, $1200 or so, being quite delighted with a profit of $600 in a few days' time (we placed this hypothetical trade around the beginning of Sep.).

Delta, the positive and negative

I came across a misconception about the deltas for puts and calls.  Someone put forth that a Sept. expiry Bull Call Spread on AAPL was the same as a Sept. expiry Bull Put Spread with similar strike prices.  In fact, the two strategies are diametric opposites.  That is because calls and puts do NOT have the same deltas, even when accounting for the fact that put deltas are represented by a negative number.  So, the AAPL Sept. 710 call has a delta of .0159 and the Sept. 730 call has a delta of .0000.  Since a Bull Call Spread is a debit spread, the cost for this spread is tiny, $.10 x .02=$.08 per contract, or $8.  The same strikes for the AAPL Sept. puts are 710 delta of -.9786 and the 730 put delta is -.9942.  Since a Bull Put Spread is a credit spread, the credit received would be $18.50 on a $20 spread, i.e., $1850 credit for every $2000 margin (but the "real" or effective margin is only $150=2000-1850). 

But, and this is a HUGE but -- with September expiry, you are giving no time at all for the stock to move.  Sept. expiry has an enormous theta influence (meaning time erosion).  If you buy the Bull Call Spread, it would cost you nearly nothing ($0.08 or $8 per contract), but the likelihood of that spread rising are almost nil, zero, zilch.  You know why?  Because the delta is 0.  The delta determines how much the option will move for every $1 move in the underlying stock.  With a delta of 0 and only 3 weeks to expiry, you would need a miracle for your $8 to go anywhere.  Of course, $8 is not a lot of money, so you may want to play with it.  But that would represent the true analogy to a lottery.

As for the Bull Put Spread, even though the credit is enormous, the Sept. expiry still poses a problem because of its short nature.  Yes, the deltas are huge (and are represented with a negative sign), which imply just about a 1:1 move of the options for every $1 move in the stock, but again, you are giving a very short time for the stock to do anything.  Very risky.

I am in the process of writing a book on this.  Stay tuned, if you're at all interested

Deep In The Money Bull Put Spreads

Someone compared a Deep ITM Bull Put Spread strategy to a lottery.  Indeed, it is anything but.  Rather, it is a very sound, safe strategy.  Consider that Bull Put Spreads are credit spreads, and the deeper ITM you go, the bigger the credit (i.e., money in your pocket).  Also, the farther out you go in time to expiry, the greater the chance that the stock will make a big move.  For example, let's take AAPL.  At its current market price, $676 or so, a Deep ITM Bull Put Spread might be something like a 2014 expiry 770/780 Bull Put Spread, which will fetch approximately $700 per margin of $1000 per contract ($770-$780=$10 x100 per contract=$1000), or 70% return, with a risk of 30%.  How do I figure the risk?  Simple: You receive $700 credit for each contract, and while the margin requirement is $1000 per contract, the $700 mitigates against that, thus reducing your out of pocket, and putting you at risk for only $300 IF the stock does not make the expected move, and IF you choose to keep it open until expiry.  In this case, you are about $100 ITM (AAPL $676; strike price $780), but your risk is only 30% if AAPL fails to reach $780 by Jan. 2014.  Moreover, you are not obliged to hold on to this spread until expiry.  If AAPL comes out with new products or wins another legal case, or declares a split, or whatever, it could surge, thereby lowering the spread amount, in which case you can buy it back to close.  Even if AAPL does not surge, but simply meanders slowly through the months, at $780, you are assuming a $104 rise in the stock price, which represents a 15.3% rise in 18 months, certainly within the realm of possibility for this stock.  Again, the credit (money in your pocket) is 70% on a risk of 30%.  In my book, that is not a lottery ticket at all, but a very sound strategy.

A Bull Put Spread is a strategy where the underlying stock can stay the same (you profit by the erosion of time), rise (you profit by the decrease in the puts) and even decline a little (by the amount of the credit received).

Is there a risk to this strategy? Yes, and here it is: If AAPL falls precipitously in price, the Bull Put Spread INCREASES in value.  Thus, it may trigger a margin call, unless you are very well funded.  The operative word here is may.  There are many situations where the market takes a tumble, even a severe correction, yet nothing happens to your long-term positions.  On the other hand, you may be called upon to reduce your margin, in which case, you simply buy the spread to close.

Remember: A PUT increases in value as the underlying stock price decreases.  A CALL increases in value as the underlying stock price increasees.

Suggestive Lexicon - Even More Interesting Tactics

I'm talking here about being naked and legging in and out.  Don't get carried away - I didn't make these up, I swear!

I love to sell naked puts.  That is, in fact, my favorite strategy.  But I also love Bull Put Spreads.  Let's see what I did with AAPL.

When AAPL was trading around $500, I sold to open (STO, in the jargon) a 2014 LEAP put at a strike of $450.  When AAPL rallied after earnings, I bought back that put to close (BTC) for a profit, and rolled out to 2014 $500 strike.  When AAPL again rallied, I "covered" this naked put with a long put by creating a Bull Put Spread - I bought to open (BTO) a 2014 $450 put.  In time, AAPL has continued to defy gravity, rising ever more, and I have been keeping a keen eye on my short puts.  With the imminent launch of the iPad 5 in September 2012, my $500 expiring in 2014 put had before very profitable.  I therefore placed a trailing stop of $2 to buy it back to close, in order to secure my profits.  I kept my long $450 put intact, in case the stock rallies, and then takes a tumble as other traders also take profits.  In that event, my long put would increase in value.

Here is what I love about Bull Put Spreads: As the name implies, you put those on with a bullish expectation on the underlying stock.  But with Bull Put Spreads, you needn't be all that bullish - just bullish enough.  One of the benefits of doing Bull Put Spreads is that you are getting money into your account immediately, because these spreads are credit spreads.  Another benefit is that, if the underlying stock tumbles significantly, your long put becomes profitable, and when that happens, I like to sell it for a profit, thus "legging out" of the spread.  I took a credit to begin with; I'm now selling the long put at a profit, thereby taking in more money; and I'm leaving the naked put in place with the expectation that the stock will recover.  Such was the case with CMG.  It had gone from about $340 down to $285, and then stabilized.  At that point, I wrote a Bull Put Spread expecting the stock to find its legs again.

Adjusting the Legs

Yesterday, I set up a Strangle With a Twist on Netflix (NFLX) right before earnings.  NFLX came out with earnings which were very positive, but "guided" lower.  The stock dropped in after-hour trading, and is trading considerably lower this morning, down about $16.75 at this writing.

Recall that I had two spreads on the stock: May 2011 $260-$265 Bull Call Spread and the May 2011 $235-$240 Bull Put Spread.  Both spreads are bullish; both spreads were set to expire May 2011.

With the stock currently down about $16.75, the call options are trading lower (the call options are currently out of the money - OTM), while the put options are trading higher (the put options are currently in the money - ITM), I have executed a few adjustments, as follows:

I bought to close (BTC) the May 2011 $265 call options for $2.90 ($290 per contract).  I sold them yesterday at $9.75 ($975 per contract), so my profit on this leg is $6.85 ($685 per contract).  That leaves a Long Call at the $260 strike expiring May 2011.  This is a Long Call (Long means that I own this position), therefore, there is no Margin Requirement.

I sold to close (STC) the May 2011 $235 put options for $10.35 ($1,035 per contract).  I bought them yesterday at $8.25 (of $825 per contract), so my profit on this leg is $2.10 ($210 per contract).  That leaves a Naked Put at the $240 strike expiring May 2011.  This is a naked position, therefore, there is a Margin Requirement of $5,977. 00.

Why did I adjust these legs?  From past experience, it seems that there is a knee-jerk reaction to negative news, and I am betting that the selling action is overdone, and the stock will recover.  So far, by removing those two legs (the short call* and the long put*), I have put $895 back into my account.  I opened both spreads yesterday at almost no cost to me.  My risk here is that the stock will not recover to the $240 strike naked put, in which case the stock will be put to me, and I will be obligated to buy it at the strike of $240 (refer to the lexicon for definitions).  As expiration approaches, I can reevaluate my position to see if the fundamentals of the stock are still interesting enough to wish to hold the stock, and if not, I can simply buy back to close that naked put, thereby relieving myself of that obligation.  In the event I do wish to allow the stock to be put to me, my break-even cost would be $240 (the strike price) less the profit of $895 I just realized, or $231.05.  Looking out to some long-term call options, selling a covered call would bring down the price even more.

With the stock currently trading at around $236, the $240 strike naked put is trading at around $12, which is $4 in the money (ITM) - $240-$236 - and a full $8 out of the money (OTM), or time value.  With May expiration being just 3 weeks away, the Theta of the option erodes extremely fast.  The Theta refers to how much value an option price will lose with every day that passes.  The closer to expiration, the faster an option loses value.

On May 11, 2011, the market started to jiggle (to the downside) a bit more than I like.  NFLX was trading up to $241, but then regressed down to $238, so I decided to roll out my naked puts to June 2011.  By rolling out, I closed (BTC) my May 2011 open position $240 Naked Put at $6.31 and opened (STO) a new June 2011 $240 Naked Put for $12.61, thus pocketing a profit on the May position of $3.74 ($374), and taking in a premium of $12.61 per contract ($1261) for the new June 2011 naked put.

Bullish on BTU

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BTU is climbing in price, to a current $65 +/-.  I feel bullish long term on this stock.  Therefore, I have placed a bullish position to expire in 2013 for a credit of $500.  The entire position consists of a Bull Call Spread and Selling a Naked Put.

Bull Call Spread

BTO 2x 2013 $65 call @ ($18.35)

STO 2x 2013 $70 call @ $15.86

 

DEBIT: ($2.49) x2=($4.98)

 

-and-

STO 1x 2013 $65 put = CREDIT $11.20

Margin Requirement for the Naked Put $2,468.00

Variations on a Theme - "Risk Reversal"

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The market has rallied hugely since the bottom in 2009.  It was due for a correction, and the "excuse" for such correction (selling) came from the Libyan mayhem and the Japanese earthquake and tsunami of March 11, 2011.  In a matter of a couple of weeks, the market gave back about 8% of its value. 

I trade stocks and options that are concentrated in the NASDAQ.  The proxy for the NASDAQ is the stock QQQQ (Q's).  The Q's closed at $54.45 on March 18, 2011.  I believe that if the current price holds, it will represent a floor or support to the current price, which should stabilize and climb from here.  Here is a way to create a bullish Risk Reversal on the Q's:

Buy to open 2012 $55 strike calls = ($4.60)

Sell to open 2012 $60 strike calls = $2.26

-and-

Sell to open 2012 $50 strike puts = $3.47

NET CREDIT $1.13

This is a position where you BUY-SELL-SELL.  What does this position do?  If the Q's rally from here, the OTM call spread will increase in value, and the OTM put will expire worthless.  The Q's would have to remain above $50 in order to collect the entire premium of $3.47, and would have to rally to at least $57.34 just to break even on the Bull Call Spread ($55-$60).  If the Q's merely remain above $50 by expiration in 2012, my entire profit will be $1.13. 

Let's go deeper in the money. 

BTO 2012 $50 calls=($7.69)

STO 2012 $52 calls=$6.22

-and-

STO 2012 $50 puts=$3.45

NET CREDIT $1.98

In this scenario, I have created a Bull Call Spread with strikes that are in the money (ITM) that cost me $1.47 for the potential to make $2, while simultaneously selling a naked $50 put.  What I am expecting is that the Q's will not only remain above $50 by January of 2012, but will, in fact, remain above $53.47 ($52 higher strike call+premium paid) in order to at least recover my outlay for the spread.  The margin requirement for this position is listed as $791.  This means that my ROI would be 25%. 

If overnight there are some terrific news that push the entire market up, I might simply "leg into" this position.  For example, I might BTO the 2012 $50 Q's calls for $7.69 and STO the 2012 $50 puts for $3.45 for a DEBIT of $4.24, and wait for a rally before selling the $55 calls to create the Bull Call Spread. 

Another possibility is to use the above Net Credit of $1.98 to purchase as many OTM calls as I can to participate in an upside.  For example, the April 2011 $56 calls are currently fetching $0.72, therefore, I might BTO 2 contracts for $1.44.

RISK REVERSAL

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How to protect one's stock portfolio for FREE, or even get paid for doing so

As the name suggests, Risk Reversal is a hedging strategy for the reversal of risk using options.  Risk Reversal is used to hedge a position, or protect a position without any additional cash outlay.  In other words, what one is essentially doing is insuring position against catastrophic loss, while positioning oneself for potential gains.

In a Risk Reversal, one would use the premium received from the sale of a call or put option to finance the purchase of the opposite option for a minimal or no outlay of additional funds.  Let's see how this words with a specific example:

Verizon (VZ) closed at $35.84 on March 18, 2011.  The 2013 (LEAPS) out-of-the-money $30 strike puts are listed at $3.10 to sell.  If you sell the $30 LEAPS puts, you will receive a premium of $3.10.  By selling this put, you are obligating yourself to buy the stock at the $30 strike.  This represents a risk below $26.90.  In other words, VZ would have to decline to below $26.90 before you start losing money on this position.  Technically, VZ can decline to 0, but you are selling the $30 strike because you are feeling bullish on VZ, and expect its price to rise in the next two years.  When you sell a put, your maximum profit potential is the premium received, in this case $3.10.

Since you are bullish on VZ, you would simultaneously buy an out-of-the-money LEAP call option at the $37 strike for $2.91.  This position would be paid for by the premium received for the puts, and would also position you to profit in any upside of VZ.  Your total Risk Reversal position in this case would create a CREDIT of $0.19 per share, and would position you for any upside in the stock.

Buy OTM Call + Sell OTM Put

Suppose you are bearish on a stock, say, Microsoft (MSFT).  You might create a Risk Reversal that takes the opposite stance, to wit: buy an out-of-the-money put (that would protect the downside) and sell and out-of-the-money call.

Buy OTM Put + Sell OTM Call

MSFT closed at $24.80 on March 18, 2011.  By buying an out-of-the-money LEAPS $22.5 put, you would spend $2.95 per share ($295 per 100-share contract).  You are thus protecting any potential decline in the stock below $22.50 between now and 2013.  In order to finance this insurance, you would sell a call, say the 2013 LEAPS $25 strike call for $3.25 ($325 per contract), thus creating a CREDIT of $0.30 ($30 per contract).  You have just positioned yourself to profit should the stock rally and protect yourself should the stock plummet.  And you did this for a CREDIT.  Can't do better than that on your house!

If one were to buy insurance to protect one's home or car, one would have to spend some money for that insurance.  The same goes for stock.  But unlike the cost of insurance for a home or car, in a Risk Reversal one might also profit should the asset appreciate significantly in price.

Here is another possibility using the QQQQ (closed at $54.45 on 3/18/11)

In order to protect from any further declines in the stock, which is a proxy for the NASDAQ, you might buy an out-of-the-money put and sell an out-of-the-money call.

The 2012 $52 strike put costs $4.15 to buy. 

The 2012 $55 strike call pays $4.48 to sell.

Net effect:  CREDIT $0.33 per share, or $33 per contract.

The effect of creating this Risk Reversal is to protect from any further declines in the Q's, and being paid for such protection.  As long as the Q's remain below $55 by 2012, the call premium of $4.48 you received will erode because of the time value, and the puts that you purchased will increase in value as the Q's continue to decline.  If, however, you expect the Q's to rally from now until January 2012, you may also use some of the CREDIT you received to purchase out-of-the-money calls to participate in such rally.

Ratio Backspreads

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The market is down big over the past few days, partly in response to the Japanese disaster in Sendai, and also becuase this is a perfect opportunity to take profits from what has been a tremendous run.  We were stretched.  It was time for a breather, and breathers are generally good for the market.  Don't panic. 

In that vein, doing backspreads is probably not such a bad idea at this time, when some stocks have really taken a terrible drubbing.  To wit: ESRX has traded down over the past two days to $51.80 at close today.  If you still believe in the long-term fundamental story of ESRX, but wish to protect against further declines, you could create a ratio call backspread consisting of a Bear Call Spread and a Long Call.  Let's see how this works:

ESRX   $51.80

BTO  10x April 2011 57.5 call = ($0.26) = ($260)

STO 5x April 2011 55 call=$0.62=$310

Net Credit=$50

In this trade, you purchase twice as many long calls that are farther out of the money as you sold short calls.  You received a credit for this position.  Therefore, if ESRX continues to decline; or if it stays the same between now and April expiration; or rises just a bit, you would be "safe" with the nominal $50 credit.  The beauty of this spread is that, if ESRX has been taken down along with the entire market because of no bad news of its own, it can rally to the moon and you would make money becuase you have 5 long calls that are available to benefit from such a rally.  If, however, the stock declines, you are protected down to $0.  In truth, you protected yourself down to $54.50, below which there can be no more losses in this position, since you capped the downside.  But since you sold the 55 call, you sold someone the right to buy the stock from you at 55.  If the stock rallies, remember that you own the 57.5 calls.  If you're asleep at the wheel and do not monitor your position, the worst case scenario is that you will have your position exercised to the tune of $1,250 (55-57.5 calls) but you received $0.36 credit per spread on the 5x, which mitigates the "loss" to $2.14.  Your "loss" therefore would be $1,070.  The $57.5 long calls are in place in the event the stock rallies much higher.