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This trade assumes that the underlying stock will NOT move down more than 42% in the next month.  If these trades are done together (as I am illustrating) it is an INCREASED risk position.  This is a Bull Put Spread (Credit Spread)

Position:

Buy QIUUA September 5 Put for          $0.35

Sell QIUUU September 7.5 Put for      $1.20

Net                                                                    $0.85

Break even for this position is OSIR trades for $6.65 ($7.50 – $0.85) on expiration.  Today OSIR is trading for $11.75.  This would be a decline of $5.10 in the next month, or 43%.  Possible, but not likely.

Maximum Loss would be $1.65/share (+ trading costs) OSIR – $5.00 or less.

Maximum Gain would be $0.85/share (- trading costs) OSIR – $7.50 or higher. 

Assuming $.15/share trading costs the gain would be $0.70 ($0.85- $.15) for a return of 28% ($0.70/$2.50) in one month, or 336% APR.

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Here is a Bull Put Spread (Linn Energy:LINE) a Credit Spread:

Sell October 2009 $20 Put on LINE (QGJVD) for     $2.05

Buy October 2009 $17.50 Put on LINE for                 $0.95

Net                         +$1.10 (less trading costs)

Max. Gain               $1.10 (less trading costs)

Max. Loss               $1.40 (+ trading costs)

Linn Energy is trading for $19.66 at the close of trading today June 15, 2009.

If Linn Energy is trading for $20.00 or more on October 17, 2009 both puts will expire worthless, we get to keep the $1.10 (less trading costs) premium.  If Linn Energy is trading for less than $17.50 we will suffer the maximum loss.  In between $17.50 and $20.00 we will have to make a calculation for the gain or loss.  I feel this is a great trade because Linn Energy is paying a +12% dividend and their earnings should be very solid as they have hedged their product for the next three years, at favorable prices.  I do not believe that Linn Energy will decline from here.

We are risking $1.40 (+ trading costs) and the return that I am looking for is about 78% in 4 months or 235% APR.

The Bull Put Spread is set up by buying a LOWER strike Put while simultaneously selling a HIGHER strike Put, both with the SAME expiration date.  This trade is also known as a Vertical Spread, because the expiration months are the SAME.  The Bull Put Spread is a Credit Spread, meaning you will receive a higher price for the Put that you sell than you wil pay for the Put that you purchase.

In order to enter this position the investor will have some beliefs.

          1)  She believes that the underlying security will stay the same or go up.  Depending on the strikes chosen, the underlying security can even go down a little and this position will still make money.  That is why this position has the word Bull in the name, it has a bullish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, down, the position can lose 100% of the money at risk.  The good thing about a vertical spread, however, is that the options WILL retain some value, up until, expiration.  This means that a 100% loss can be avoided.

Lets look at an example:

In a recent Trading Idea I said to buy a July 2009 $12 Put while selling a July 2009 $13 Put on SLV  (IShares Silver ETF).  Here is the Risk/Reward graph for this position. 

Bull Put Spread - SLV (IShares Silver ETF)

The Maximum Loss is $0.60 ($1.00 difference in stikes – $.040 premium), and this will occur if SLV is trading below $12 at expiration, July 18, 2009.

The Maximum Gain is $0.40 (Premium recieved for position), and this will occur if SRS is trading above $13 at expiration, April 18, 2009.

The breakeven is if SLV is trading at $12.60 at expiration, July 18,2009.  The breakeven for this postition can be calculated by taking the strike price for the option sold (the $13 Put) – the premium received ($0.40).  If SLV is trading below $12.60, this position will have a loss.   If SLV is trading above $12.60 this position will have a gain.

Today SLV is trading for $13.68.  This means that SLV can lose 5% ($0.68)between now and July 18th and this position will still have the Maximum Gain.  SLV can lose 7.9% ($1.08) in that time frame and this position will Breakeven (not including trading costs).  SLV has to lose more than 12% in this time frame to incur the Maximum Loss.

The basic options spread involves the purchase of one option and the sale of a corresponding option.  Spreads can be done with either calls or puts.  Spreads can work very well by limiting the risk involved, however, they also limit the upside.  Spreads can be a very cost effective way to profit from the stock market, while at the same time limiting the risk.

Spreads have many names, but do not let that scare you.  As I said before, half of understanding anything is learning the “language”.  I will attempt to explain them in plain English.

The first Spread that I will explain is the Vertical Spread.

The Vertical Spread consist of buying a Call (or Put) and selling a Call (or Put) with the SAME expiration month, but with DIFFERENT strike prices.  That’s it.  Not very difficult.  This position will have a LIMITED loss potential, as well as, a LIMITED gain potential.  In other words, when you enter the trade you will KNOW the maximum gain and the maximum loss that can occur. 

Sometimes, you will hear of a Credit Spread or a Debit Spread.  A Credit Spread means that you will receive a positive inflow into your account (a credit) when you open the trade.  A Debit Spread means that you will pay (a debit) when you open the trade.

There are essentially four different Vertical Spreads that one can enter, they are:

          1)  The Bull Call Spread

          2)  The Bear Call Spread

          3)  The Bear Put Spread

          4)  The Bull Put Spread

next up – a discussion of the Bull Call Spread