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Options Spreads Trading

TradingPub Admin | August 25, 2014

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At the TradingPub we strive to connect you with top professional traders so you can listen and learn from their trading techniques and methods. Joseph Cusick is the VP of Wealth and Asset Management at MoneyBlock and shared some of his option spread ideas and techniques during a recent webinar hosted at the TradingPub.

Below is a quick summary of his presentation and full video recording.

The main focus of Joseph's presentation was centered on understanding the four main set-ups that comprise an options spread trade:

  • Long Bull Call Spread
  • Long Bear Call Spread
  • Short Bull Put Spread
  • Short Bear Put Spread

LONG BULL CALL SPREAD

An important feature of options trading is that you can pick longer time frames for your trades. This kind of trade structure allows for mitigation of some of your position risk, even if the underlying asset is going against you. With this in mind, trading options allows to sit on a position during time of volatility or uncertainty and not have to adjust or exit your trade.

To pick a strike price, you can look at the option's current trading prices and then the probability of success at each of those strike levels. A long bull call spread is constructed by buying a call option with a low strike price and selling another call option with a higher strike price. The example below involves the Michael Kors Holdings Limited stock with ticker symbol KORS. The stock was trading at $82.23 when Joseph first started looking at it, but then the price dropped. The question then is which strike price do you pick for your long bull call spread strategy?!

Joe 01

As seen in the above image the price of the stock drops below the $82.23, as marked with the red arrow.

Joe 2

You can see that if you buy the $90 calls you have only 27.41% probability that the option will expire in the money, or in other words, nearly 73% that it will expire worthless. But if you look at the $75.00 calls you see that is has nearly 70% chance of expiring in the money. However, to buy the $75 call you have to pay a high premium of $9.20. So you can buy the $75 call and sell the $90. At this point you will have limited risk and reward, but the strike is in the money.

Joe 3

LONG BEAR PUT SPREAD

Next we look into a long or bear put spread strategy. This strategy will be in the money if the market continues to move down. When you hear long or debit strategy, for those new to options trading, that means that whatever you paid for the strategy is all you would have risked.

The stock shown in the image below is Transocean with ticker symbol RIG. It was originally trading at $43.18, when Joseph started looking at it. Then, as shown with the red arrow in the image below, the stock started trading lower than the $43.18 original level of interest, which was great for implementing a put spread strategy.

Joe 4

To choose a strike price here we can see that the stock has been in the $40-$45 range for the months of June, July and August and picking within this range will be logical. The put with a $40 strike  at $.77 has a nearly 75% chance of being out the money at expiration, so it is not a very good opportunity. The $46 put is selling for $4.30, as seen below, but has nearly 74% chance of expiring below this price, making it in the money.

Joe 5

One thing to keep in mind with these strategies is that you do not have to hold your positions until expiration, you can get out of them before that time and take 40-50% profit vs. the entire possible return, but you are not exposing your position to the rapid price change risk.

The chart below shows the profit potential of a possible options trade. If we buy the $41 and sell the $40 puts we have a cash outlay of only $38. In comparison if we sell a $40 put and buy a $46 one the cash outlay is  $106.

Joe 6

SHORT BEAR CALL SPREAD

A bear call spread is a limited profit, limited risk options trading strategy that can be used when the options trader is somewhat bearish on the underlying security. It is entered by buying call options of a certain strike price and selling the same number of call options of lower strike price (in the money) on the same underlying security with the same expiration month.

We will use the same stock example as above, RIG, and take a look at a short bear call spread option strategy. Again, this is an opportunity to short the market and have limited risk and defined return. In making a decision what strategy to pursue, you have to look at both the strike prices and probabilities of the outcome of a trade being successful.

Joe 7

If you look only at the prices of selling at the $40 or the $41 you can see that those seem pretty attractive, but if you actually look at the probability (all shown on above image), you will see that the probability of those particular levels of strike prices are at high level of expiring above the price and with this kind of bear strategy we want the underlying asset to expire below the strike price to be in the money.

So what Joseph suggests is to sell the $42 for $1.80 and buy the $46 at $.50, as seen below.

Joe 8

SHORT BULL PUT

A bull put spread is executed by selling higher strike in-the-money put options and buying the same number of lower strike in-the-money put options on the same underlying security with the same expiration date. Options traders, using this strategy, hope that the price of the underlying security goes up far enough, such that the written put options expire worthless.

Selling puts is similar to selling covered calls as far as the risk reward goes, but some people view those as more risky and are not very fond of being involved with this type of strategy. However, we will review an example below.

Here selling the $75 puts will only bring you $1.70 versus the $9.20 of the $90 put, but the first one has a much higher chance of expiring above the strike (68.20%), making it a more attractive opportunity.

Joe 9

If we buy the $75 and sell the $80 puts the break event price is at $76.70, as seen below, and this is nearly $6 off of where the price is currently. But the risk to reward ratio is 2:1. The other strategy is to buy the $75 put and sell the $90 put but here the risk to reward ratio is only 1:1, this making it less attractive, as seen in the image below.

Joe 10

Given the sheer number option choices that are available to trade can make it very challenging to find good trading opportunities. To help solve this problem, Joseph uses Tradespoon to help him spot the best emerging setups. Tradespoon is a software service looks for under or overvalued stocks based on qualitative and quantitative analysis. It then ranks stocks in a given sector, and lists those that are trending up, down or sideways using a value investing based approach. Tradespoon will also select the best time horizon for a trade, and the short-term trend for each vehicles on its watch list including the probabilities at each strike price.

Tradespoon is a powerful tool and indispensable to traders like Joseph that rely on it on regular basis to sift through the myriads of potential trades to help find those that have the highest potential for success.

If this is something you are interested in, then you can try Tradespoon's service and determine for yourself if it can help you improve your options trading consistency.

Simply CLICK HERE to access the service trial.

WATCH FULL VIDEO WITH JOE HERE: