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This vertical spread trade was started on March 23, 2009.

SLV traded for $13.17 at the close on Friday July 17th.  Both Puts, the one sold (written) and the one bought (long), expired worthless.

We realized the maximum gain for this trade of $0.40 (less trading costs), if we assume $0.15/share as trading costs, we have a gain of $0.25/share.  We risked $0.75/share, which makes our return on this trade 33% (0.25/0.75) for four months or approximately 100% APR.

Please note that $0.15/share trading costs assumes that only one option contract was used.  These costs go down (dramatically) if more than one option contract is used which would raise the return of this trade.

The Bear Put Spread is set up by buying a Higher strike Put while simultaneously selling a LOWER strike Put, both with the SAME expiration date.  The Bear Put Spread is a Debit Spread, meaning you will pay a higher price for the Put that you purchase than the price of the Put that you sell.

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 down.  Depending on the strikes chosen, the underlying security can go up a little and this position will still make money.  That is why this position has the word Bear in the name, it has a bearish bias.

          2)  The investor understands that IF the underlying stock moves counter to the postion, in this case, up, the position can lose 100% of the money invested.  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:

Lets assume that GE (General Electric) fits the criteria.  GE is trading for $10.78 on March 27, 2009.  I would buy an April 2009 $12 Put, for $1.55, while selling an April 2009 $11 Put, for $0.90 .  Here is the Risk/Reward graph for this position.

 

Bear Put Spread - GE

The Maximum Loss is $0.65 (+ Trading Costs), and this will occur if GE is above $12 at the expiration, April 18, 2009.

The Maximum Gain is $0.35 ($1 difference in strikes -$0.65 premium paid) (- Trading Costs), and this will occur if GE is below $11 at the expiration, April 18, 2009.

If GE is between $11 and $12 at expiration, April 18, 2009, then the gain/loss will be -$0.65 (the cost of the spread) – the price of GE + $12 (the price that you can sell (put) GE).  Therefore the breakeven point for this position is $11.35 (-$0.65 – $11.35 + $12 = $0) (not including trading costs).

This trade would be entered when GE was trading for $10.78.  This means that if GE stays the same or goes down OR goes up $0.22 (2.0%) this position will still make the maximum gain.  GE has to go up to $11.35, a gain of $0.57(or 5.3%), for this position to start to lose money. 

This position cost us $0.65/share and has an upside potential profit of $0.35/share.  That would be a 54% gain in less than 1 month.  Which is an approximate 650% APR (Annual Percentage Rate).

The Bull Call Spread is set up by buying a LOWER strike Call while simultaneously selling a HIGHER strike Call, both with the SAME expiration date.  The Bull Call Spread is a Debit Spread, meaning you will pay a higher price for the Call that you purchase than the price of the Call that you sell.

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 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 invested.  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 previous Trade Idea I suggested a Vertical Spread.  I said to buy a July 2009 $35 Call while selling a July 2009 $55 Call on SRS  (Proshares Ultrashort Real Estate Fund).  Here is the Risk/Reward graph for this position.

SRS - Bull Call Spread

The Maximum Loss is $7.80 (+ Trading Costs), and this will occur if SRS is below $35 at the expiration, July 18, 2009.

The Maximum Gain is $12.20 ($20-$7.80) (- Trading Costs), and this will occur if SRS is above $55 at the expiration, July 18, 2009.

If SRS is between $35 and $55 at expiration, July 18, 2009, then the gain/loss will be -$7.80 (the cost of the spread) – $35 (the price that you can buy (call) SRS) + the price of SRS.  Therefore the breakeven point for this position is $42.80 (-$7.80 – $35 + $42.80 = $0) (not including trading costs).

This trade was entered when SRS was trading for $59.44.  This means that if SRS stays the same or goes up OR goes down $4.44 (7.5%) this position will still make the maximum gain.  SRS has to drop to $42.80, a loss of $16.64 (or 28%), for this position to start to lose money.  The 52 week low for this ETF is $48.00.

This position cost us $7.80/share and has an upside potential profit of $12.20/share.  That would be a 256% gain in approximately 6 months.  Which is an approximate 500% APR (Annual Percentage Rate).

One other note on this example:  This position is called a Bull Call Spread, that means that I was “bullish” on SRS.  However, SRS is an “Ultrashort” ETF, which means that it moves up when some index, in this case the real estate fund, goes down.  In essence, this position was a “bearish” position.  I hope I have not confused the situation.

Many traders start their Option trading with one of two very simple positions.  The two positions are the Covered Call and the Married Put. 

The Covered Call Strategy involves writing (selling) a call against stock that is already owned.  If you write a Call without owning the stock it is called a “naked” call.  The Covered Call Strategy can be a procedure that makes any stock a “dividend” stock.  This strategy is perfect for a buy and hold investor.  This strategy makes a few assumptions:

     1)  The investor likes the stock and wants to own it.

     2)  The stock is not too volatile, meaning the price of the stock does not vary much, or stays within a channel.

     3)  The investor is willing to accept the full risk of a downward move in the stock.

There are two types of positions that can be employed when using the Covered Call Strategy.  The first, which is the one I will discuss here in detail, is selling near the money options that expire in the next month or two, and the second is selling extended duration options that are deep in the money.  If people want examples of strategy #2 please leave a comment.  In strategy #1, we sell options that expire in a month or two in order to capture the time value of the option.  The time value of an option accelerates to $0 as the option approaches expiration. 

For this discussion, lets look at Archer Daniels Midland (ADM).  Here is a chart of the last three months (I am using the last three months, because before that three months everything fell dramatically, and I am using current examples)

 

3 month Chart of ADM March 13, 2009

3 month Chart of ADM March 13, 2009

As you can see ADM has basically stayed between $24 and $30, so lets say we buy 100 shares today at $27.76 (full cost would be $2,776.00 + trading costs).  Here is a list of the near the money Call options expiring in April.

April Call Options - ADM

We could write (sell) the ADMDF $30 strike option for $0.95 (I would try a limit order at $1.00).  This $0.95 represents time value as there is NO intrinsic value in this option because it is Out of  the Money (OTM).  The ADMDE option priced at $3.50 has $2.76 of intrinsic value ($27.76 – $25.00) and $0.74 of time value ($3.50 – $2.76).  At this point we want ADM to continue to appreciate, slowly.  Remember, the investor wants to own this stock (would own it without writing calls).  Here is the risk/return graph for this position.

ADM Covered Call

At this point, there are two possible outcomes:

     1)  ADM stays below $30, then the option expires worthless and we can sell the next option.  The return for the month is $0.45 ($0.95 less trading costs, I will assume $0.50, and this includes the trading costs on the stock, which is only paid in the first month) option premium received for a return of 1.6% for the month ($0.70 if we do not include the trading costs of the stock, for a 2.52% return for the month).  This as a simple Annual Percent Return (APR) of 19.45% (or 30.26%) not including compounding.

     2)  ADM is above $30, then the option will be exercised.  We sell ADM for $30 (this is the strike price of the option that we sold).  The return for the month is $2.44 ($30 Strike price – $27.76 Purchase price + $0.95 Option premium received – $0.75 trading costs) or 8.79% for the month (105.48% APR).  If this happens we can decide to repurchase ADM or look for another opportunity.

These outcomes do not include any dividends received for owning the stock through an ex-dividend date, if this were the case the dividend would need to be included as a gain in the calculation.

The worst case for this strategy is for the stock to decline drastically.  If this happens, the investor will need to decide whether to sell options that could produce a realized loss, sell the stock for a loss or hold the stock and hope for a positive return.

Next the Married Put…

When I own an asset, it is also known as being LONG an asset.  If I buy a stock, I am long the stock.  Assets can take many forms, a few examples are stocks, bonds, real estate, commodities, automobiles, etc.

When you purchase an asset, there are three possibilities that can happen in the future.
1. The asset can appreciate, meaning you will be able to sell it for more than you purchased it. This will result in a gain, and depending on the type of account it is held in, you may owe taxes on the gain.  These are the assets that we want to own.
2. The asset can retain its value, it neither appreciates nor depreciates. You will be able to sell this asset in the future for the same amount that you paid for it.
3. The asset can depreciate, meaning that when you sell it in the future, you will sell it for less than what you paid for it.  This will result in a loss, and depending on the type of account it is is held in, you may have a loss to claim on taxes.  Who would purchase an asset that depreciates?  Every adult that I know owns at least one depreciating asset……their car.

This is a risk/return graph for the owning an asset, I will use Apple on February 6, 2009 for this example.

 

Apple as of Februart 6, 2009

Apple as of Februart 6, 2009

As you can see, at any price lower than the purchase price of $99.72 (the closing price on February 6, 2009), you will incur a loss.  At any price above $99.72, you will have a gain, and at $99.72 this will be an even trade.

I have simplified this example, please remember that some stocks will have a dividend, stock splits, etc. that will affect this calculation.  For example, if you were to receive a dividend, it could be argued that this reduces your cost.  Please also remember that time value can be a factor in the calculation.