I picked today's image to illustrate how looking at things "upside down" can actually reveal a lot about the picture, right-side-up. In other words: today we're going to flip-flop perspectives from long CALL spreads to long PUT spreads and see what's revealed about both strategies in the process. (For newcomers to this series: welcome! So far in this group-o-posts we've defined long call spreads, talked about time's effects on the position, explored delta and volatility, and most recently compared long call spreads to synthetic collars.)
What's a long PUT spread?
Let's start with defining terms, using an example.
ABC @ 109.36
Buy 1 ABC Jun 110 Put @ - 3.70
Sell 1 ABC Jun 105 Put @ + 1.75
_________________________
Net Debit -1.95
In a nutshell, we've constructed a bearish spread by buying an ITM put and offsetting that cost by selling an OTM put. Just like long call spreads we've discussed throughout this series, our max risk equals the net debit paid, or -1.95.
The breakeven point for this spread is the difference between the strike prices, 5, minus the 1.95 debit. That means the breakeven point falls between the two strike prices, too. Specifically, to calculate the breakeven, take the higher strike price, 110, and subtract the 1.95 debit from it.
Max risk: 1.95
Max profit: 5 - 1.95 = 3.05
Breakeven: 110 - 1.95 = 108.05
In other words, we're rooting for ABC to drop to at least 108.05 the breakeven point and then hopefully continue on down to our lowest strike, 105 by expiration.
Let's run this spread through two analyses, first for delta and second for time premium. As we explored earlier in this series, understanding the position's net delta will give you a feel for how your position might be affected by changes in the underlying itself. It's also important to understand the net impact of time's passage on any spread, so you have a sense of where time is helping versus hurting your position.
DELTA ANALYSIS
ABC @ 109.36
Puts Price Delta
100 0.75 -0.14
105 1.75 -0.28
110 3.70 -0.49
115 6.90 -0.71
Long 110 Put - 0.49
Short 105 Put + 0.28
Net delta - 0.21
In other words, for every one-point move ABC makes downward, this long put spread will theoretically move a corresponding 0.21 cents up in value. Note how this situation mirrors the long call spreads discussed earlier in the series: the long put spread offers a lower delta than buying the 110 put outright, -.49, but its short leg also cushions the position somewhat against the effects of a drop in implied volatility and time decay.
And speaking of time decay, let's take a closer look at this position in light of net time premium:
TIME PREMIUM ANALYSIS
ABC @ 109.36
Puts Premium - Intrinsic = Time
100 0.75 0 0.75
105 1.75 0 1.75
110 3.70 0.64 3.06
115 6.90 5.64 1.26
Long 110 Put - 3.06
Short 105 Put + 1.75
Net time premium paid - 1.31
With a negative net time premium, we're paying a debit in the hopes that ABC will definitely make its move downward before expiration. Since we are buying the 'œmost' ATM option and selling the next strike OTM, this trade is very speculative, time-premium-wise. The total cost of the trade is 1.95 (3.70 - 1.75), of which 1.31 can be chalked up to time premium. This means if the stock stays where it is (109.36), this trade may be a net loser only because of time decay.
An alternative move would be to buy the 115 put at 6.90 and sell the 105 put for 1.75. This trade will cost more overall, 5.15 (6.90 - 1.75), but is more modest in terms of net time premium. This spread actually receives, .49 (1.75 - 1.26) in time premium. This means every day the stock does not move, the position may be a net winner only because of time decay. In other words, the position's total cost may be more, but can be considered much lower-cost in total time premium.
One more point on the above. When considering this trade, it helps to think in terms of total dollar amount to invest as opposed to the number of contracts. Think of it as "how many spreads can I buy with X dollars?'" The 115/105 combination will be a smaller number than the 110/105, but in actuality it is the more conservative trade.
Next week, we'll put everything together in a quick summary sheet...stay tuned!
Regards,
Brian (OG)
Options involve risk and are not suitable for all investors. Please read Characteristics and Risks of Standardized Options.
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