Bull Put Spread

When the market is volatile and you are moderately bullish on it, you might consider a Bull Put Spread. This strategy involves selling a put option at one strike price and buying a put on the same asset at a lower strike price (further out-of-the-money). Usually both options will have the same expiration date. This strategy is also referred to as a Bullish Credit Spread.

This strategy has a profit/loss picture that is similar to a Bull Call Spread, however in this case, there is a net premium that goes into your trading account when you establish the position, whereas with the Bull Call Spread, you are paying out a premium when you establish the position. Like the Bull Call Spread, this strategy has limited risk but also limited profits.

This strategy is a bullish strategy, like selling naked puts, that puts premium into your account when you establish the position. However it limits your risk by the purchase of lower priced puts, protecting you if the price drops significantly.

With this strategy, your potential profit is limited to the premium you collected for the puts you sold less commissions and the premium you paid for the puts you bought. Your potential losses are limited to the difference between the strike prices multiplied by 100 times the point value of the contract, less the cost of establishing the position. An option calculator such as Option-Aid performs these calculations for you instantaneously.

When we initiate a Bull Put Spread, the put we buy has the same expiration date, with a lower strike price (at a price point that we feel sufficiently limits our risk, without significantly lowering the premium we are collecting.

It is also important to cover risks and caveats of this strategy.

The risk of this position is limited and known as described above. Remember that the commission you pay for this position will be higher than the commission for a straight option play, because you are initiating two related option transactions.

When you initiate a Bull Put Spread, you are limiting your upside potential. If the asset price rockets skyward, then you aren't able to fully participate in that gain like you would if you had purchased a call.

It is important to analyze your expectations for the underlying asset and for the market before selecting your strategy.

Bull Call Spread

When the market is volatile and you are moderately bullish on it, you can minimize your cash invested in a position, and minimize your risk while still reaping high profit potential by utilizing a Bull Call Spread. This strategy involves buying a call option at one strike price and selling a call on the same asset at a higher strike price. Usually both options will have the same expiration date. This is a debit spread because you will be paying a higher premium for the lower strike call than the premium you receive from the higher strike call.

Market Opinion?

Moderately Bullish to Bullish

When to Use?

Moderately Bullish
An investor often employs the bull call spread in moderately bullish market environments, and wants to capitalize on a modest advance in price of the underlying stock. If the investor's opinion is very bullish on a stock it will generally prove more profitable to make a simple call purchase.

Risk Reduction
An investor will also turn to this spread when there is discomfort with either the cost of purchasing and holding the long call alone, or with the conviction of his bullish market opinion.

Benefit

The bull call spread can be considered a doubly hedged strategy. The price paid for the call with the lower strike price is partially offset by the premium received from writing the call with a higher strike price. Thus, the investor's investment in the long call, and the risk of losing the entire premium paid for it, is reduced or hedged.

On the other hand, the long call with the lower strike price caps or hedges the financial risk of the written call with the higher strike price. If the investor is assigned an exercise notice on the written call and must sell an equivalent number of underlying shares at the strike price, those shares can be purchased at a predetermined price by exercising the purchased call with the lower strike price. As a trade-off for the hedge it offers, this written call limits the potential maximum profit for the strategy.

Risk vs. Reward

Upside Maximum Profit: Limited
Difference Between Strike Prices - Net Debit Paid

Maximum Loss: Limited
Net Debit Paid

A bull call spread tends to be profitable when the underlying stock increases in price. It can be established in one transaction, but always at a debit (net cash outflow). The call with the lower strike price will always be purchased at a price greater than the offsetting premium received from writing the call with the higher strike price. Maximum loss for this spread will generally occur as the underlying stock price declines below the lower strike price. If both options expire out-of-the-money with no value, the entire net debit paid for the spread will be lost.

The maximum profit for this spread will generally occur as the underlying stock price rises above the higher strike price, and both options expire in-the-money. The investor can exercise the long call, buy stock at its lower strike price, and sell that stock at the written call's higher strike price if assigned an exercise notice. This will be the case no matter how high the underlying stock has risen in price. If the underlying stock price is in between the strike prices when the calls expire, the long call will be in-the-money and worth its intrinsic value. The written call will be out-of-the-money, and have no value.

Break-Even-Point (BEP)?

BEP: Strike Price of Purchased Call + Net Debit Paid

Volatility

If Volatility Increases: Effect Varies
If Volatility Decreases: Effect Varies

The effect of an increase or decrease in the volatility of the underlying stock may be noticed in the time value portion of the options' premiums. The net effect on the strategy will depend on whether the long and/or short options are in-the-money or out-of-the-money, and the time remaining until expiration.

Time Decay?

Passage of Time: Effect Varies

The effect of time decay on this strategy varies with the underlying stock's price level in relation to the strike prices of the long and short options. If the stock price is midway between the strike prices, the effect can be minimal. If the stock price is closer to the lower strike price of the long call, losses generally increase at a faster rate as time passes. Alternatively, if the underlying stock price is closer to the higher strike price of the written call, profits generally increase at a faster rate as time passes.

Alternatives before expiration?

A bull call spread purchased as a unit for a net debit in one transaction can be sold as a unit in one transaction in the options marketplace for a credit, if it has value. This is generally the manner in which investors close out a spread before its options expire, in order to cut a loss or realize profit.

Alternatives at expiration?

If both options have value, investors will generally close out a spread in the marketplace as the options expire. This will be less expensive than incurring the commissions and transaction costs from a transfer of stock resulting from either an exercise of and/or an assignment on the calls. If only the purchased call is in-the-money as it expires, the investor can either sell it in the marketplace if it has value or exercise the call and purchase an equivalent number of shares. In either of these cases, the transaction(s) must occur before the close of the market on the options' last trading day.

Selling Puts

Aka: Uncovered Put, Short Put, Writing Put, Naked Put

Summary

A Naked Put involves writing a Put option without the reserved cash on hand to purchase the underlying stock.

This strategy entails a great deal of risk and relies on a steady or rising stock price. It does best if the option expires worthless. The only motive for writing an uncovered Put is to earn premium income.

Overview

A Put writer (seller) who has no desire to own the underlying stock, and no earmarked resources for settling should the shares be assigned, is undertaking a highly risky strategy.

An uncovered Put strategy expects the Put to expire worthless, allowing the writer to keep the premium received at the outset. With a lot of luck, the strategy might work, but an unexpected outcome could be catastrophic. Considering the limited income potential and enormous downside risk, this strategy is not suitable for most investors. There are no guarantees against assignment, short of closing out the Put. As for that solution, it might be difficult and costly just when the investor would most want to exit: when the stock moves sharply downward.

How can a short Put writer at least reign in the risk of this risky investment? First, the investor could set aside the financial resources to take ownership of the stock at any time if assigned. Second, the investor could select a strike price more cautiously; not on grounds of maximizing premium income. Obviously, the higher the strike price, the greater the premium, but the higher the risk of assignment, too.

Cash-Secured Puts are the same as Naked Puts, but with two vital exceptions. First, the Naked Put writer has not set aside the cash to buy the stock if assigned. As a result, assignment would require urgent and possibly costly maneuvers to get hold of enough cash by settlement. Second, the Naked Put writer has no interest in acquiring the underlying stock. If assigned, the goal would be to resell the stock as quickly as possible to minimize the duration and risk of stock ownership.

Maximum Risk

The maximum theoretical loss is limited, but it is very substantial. The worst that can happen is for the stock price to fall to zero, in which case the investor would be obligated to buy a worthless stock at the strike price. The effective purchase price, however, would be reduced somewhat by the premium received from selling the Put option.

It is conceivable that the investor might have to incur some additional expenses to come up with enough cash to honor the contract on the settlement day.

Maximum Gain

The maximum gains are very limited, especially relative to the extent of risk. If the position is still open at expiration, the best that can happen is for the stock price to be above the strike price. In that case, the option expires worthless and the investor pockets the premium received for selling the Put option.

Profit/Loss

The potential profit is extremely limited. No matter how high the stock price rises, the most this investor can hope to earn is the initial premium. The best scenario for the Put writer would be a steady or rising stock price for the whole term, with no news announcements or other events to trigger greater volatility. If time passes and the Put remains out-of-the-money, it would be increasingly likely to expire worthless, relieving the investor of all obligations.

Since the premium constitutes the only benefit, some writers are tempted to write contracts with longer terms and higher strike prices. Both would increase the odds of assignment, which in this case is a very undesirable outcome. The investor would have to scramble to deliver the cash by settlement day, and make urgent plans to resell the stock afterward. The delay between assignment and notification add to the overall risk.

Potential losses are extremely large, limited only by the fact that the stock's value cannot fall below zero. At that point, the loss would be the strike price, less the initial premium received.

Break Even

At expiration, the strategy breaks even if the stock price is below the strike price by the amount of the premium received, i.e., the option's intrinsic value equals the price at which the option was sold.

Breakeven = Strike – Premium

Volatility

An increase in implied volatility would have a negative impact on this strategy, all other things being equal. Even if the investor felt that it had no correlation to a greater future risk of assignment, it would normally raise the cost of buying the Put back to close out the position.

Time Decay

The passage of time will have an extremely positive impact on this strategy, all other things equal. Every passing day diminishes the mathematical likelihood of an at-the-money or out-of-the-money Put becoming ITM by expiration.

As expiration approaches the option moves toward its intrinsic value, which for out-of-money Puts is zero.

Assignment

Yes. The risk of assignment, whether early or at expiration, is this investor's chief worry, since the investor has neither the ready cash for this purpose nor a desire to own the underlying stock. A cautious selection of strike price and careful ongoing monitoring are the best ways to decrease the odds of a costly surprise, but closing the Put out is the only way to eliminate this risk. Early assignment, while possible at any time, generally occurs when the option goes deep into-the-money.

And be aware, any situation where a stock is involved in a restructuring or capitalization event, such as for example a merger, takeover, spin-off or special dividend, could completely upset typical expectations regarding early exercise of options on the stock.

Expiration Risk

This risk applies, too. The option writer cannot know until the Monday following expiration whether assignment occurred or not. Since the goal is to resell the assigned stock as soon as possible, the delay of a weekend exposes the investor to interim stock price risk, as well as possible inconveniences in bridging the need for cash from option settlement until the subsequent stock sale settlement.

Long Call

Purchasing calls has remained the most popular strategy with investors since listed options were first introduced. Before moving into more complex bullish and bearish strategies, an investor should thoroughly understand the fundamentals about buying and holding call options.

Market Opinion? Bullish to Very Bullish

When to Use?

This strategy appeals to an investor who is generally more interested in the dollar amount of his initial investment and the leveraged financial reward that long calls can offer. The primary motivation of this investor is to realize financial reward from an increase in price of the underlying security. Experience and precision are key to selecting the right option (expiration and/or strike price) for the most profitable result. In general, the more out-of-the-money the call is the more bullish the strategy, as bigger increases in the underlying stock price are required for the option to reach the break-even point.

As Stock Substitute

An investor who buys a call instead of purchasing the underlying stock considers the lower dollar cost of purchasing a call contract versus an equivalent amount of stock as a form of insurance. The uncommitted capital is "insured" against a decline in the price of the call option's underlying stock, and can be invested elsewhere. This investor is generally more interested in the number of shares of stock underlying the call contracts purchased, than in the specific amount of the initial investment - one call option contract for each 100 shares he wants to own. While holding the call option, the investor retains the right to purchase an equivalent number of underlying shares at any time at the predetermined strike price until the contract expires.

Note: Equity option holders do not enjoy the rights due stockholders – e.g., voting rights, regular cash or special dividends, etc. A call holder must exercise the option and take ownership of the underlying shares to be eligible for these rights.

Benefit

A long call option offers a leveraged alternative to a position in the stock. As the contract becomes more profitable, increasing leverage can result in large percentage profits because purchasing calls generally requires lower up-front capital commitment than with an outright purchase of the underlying stock. Long call contracts offer the investor a pre-determined risk.

Risk vs. Reward

Maximum Profit: Unlimited

Maximum Loss: Limited

Net Premium Paid

Upside Profit at Expiration: Stock Price - Strike Price - Premium Paid

Assuming Stock Price above BEP

Your maximum profit depends only on the potential price increase of the underlying security; in theory it is unlimited. At expiration an in-the-money call will generally be worth its intrinsic value. Though the potential loss is predetermined and limited in dollar amount, it can be as much as 100% of the premium initially paid for the call. Whatever your motivation for purchasing the call, weigh the potential reward against the potential loss of the entire premium paid.

Break-Even-Point (BEP)? BEP: Strike Price + Premium Paid

Before expiration, however, if the contract's market price has sufficient time value remaining, the BEP can occur at a lower stock price.

Volatility

If Volatility Increases: Positive Effect

If Volatility Decreases: Negative Effect

Any effect of volatility on the option's total premium is on the time value portion.

Time Decay?

Passage of Time: Negative Effect

The time value portion of an option's premium, which the option holder has "purchased" by paying for the option, generally decreases, or decays, with the passage of time. This decrease accelerates as the option contract approaches expiration.

Alternatives before expiration?

At any given time before expiration, a call option holder can sell the call in the listed options marketplace to close out the position. This can be done to either realize a profitable gain in the option's premium, or to cut a loss.

Alternatives at expiration?

At expiration, most investors holding an in-the-money call option will elect to sell the option in the marketplace if it has value, before the end of trading on the option's last trading day. An alternative is to exercise the call, resulting in the purchase of an equivalent number of underlying shares at the strike price.