Market Overview

BIDU Put Spread

A lot of times option traders will look at some of the more expensive stocks like AAPL and NFLX and see a short-term bearish pattern setting up. Many of these pullbacks only last for a couple of days or weeks. Buying straight puts on higher-priced stocks on which a trader is bearish is generally a good idea but can be very expensive for many option traders. Here's a tip: traders can sometimes get around buying expensive puts by creating a lower cost bear put debit spread.

A bear put spread involves buying a put option and selling a lower strike put option against it. The cost of buying the higher strike put option is somewhat offset by the premium received from the lower strike that was sold. The maximum gain on this spread is the difference in the strike prices minus the cost of the trade. The option trader will realize this maximum gain if the price of the stock is lower than the strike that was sold at expiration. The most the option trader can lose is the cost of the spread. This maximum loss occurs if the stock is trading above the long put at expiration.

Since the mind-frame of this trade is that the bearish pullback might only last a few days, the expiration on the spread should be fairly short term. An option trader can look for expiration somewhere between two weeks and a month or so. What might also help is that more expensive stocks usually have a higher average-true-range which indicates greater movement which can either make the trade profitable more quickly or cause it to lose just as fast. As a general guideline, the cost of the spread should be about 1/3 of the difference between the two strike prices. This means that the remaining 2/3 is maximum profit potential. Look to buy the strike that is at-the-money or just out-of-the-money especially for the more expensive stocks.

Let's look at a quick example. It's early July and BIDU is trading around $146. You see the stock is approaching resistance and believe the stock might pullback for a week. The August 150 puts are about $11.30 and have a negative delta of 0.55 which means that if BIDU goes up or down a dollar the trade will lose or make about $0.55 respectively. The more BIDU goes in-the-money the more that delta should rise and vice-versa.

This might be a reasonably good trade, but spending over a thousand dollars on one option is quite expensive for a lot of option traders. Another scenario is to do the bear put spread. To lower the cost trader can buy slightly out-of-the-money and purchase the August 145 put for $8.50 and sell the August 135 put for $4.60. This lowers the cost of the trade to $3.90 but also lowers the maximum profit to $6.10. The other trade-off is now the delta difference is lowered as well to negative .17 from .55. Now if BIDU goes up or down a dollar the spread will currently make or lose only $0.17.

Using a bear put spread instead of going long puts might not always be the right answer, but at least on very expensive options, it gives the option trader a less costly alternative with a few concessions.

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Dan Passarelli is an author and the founder of Market Taker Mentoring LLC, a personalized options education service. Dan has more than 17 years' experience in the options industry and has worked as both a floor trader

Posted-In: Options

 

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