Lawrence G. McMillan analyzes Dunc's trades
This All-Star Commentary post features two Trade Notes (short put, long put,) from Dunc. Thank you for journaling your trades, Dunc!
"Opening Bull Put Spread on USO - confident this oil ETF will remain above $80 by April expiration" - Dunc short put and long put entries
Dunc,
Oil seems to be one of the few, consistent bright spots in the market these days. Let's take a closer look at your trades in the Rookie's Corner.
ROOKIE'S CORNER
USO = 85.80 as of 3/18/08 close
3/12 Trade 1: Bought to open 10 USO April 79 puts @ 2.10 USO = 86.92 as of 3/12 close
3/12 Trade 2: Sold to open 10 USO April 80 puts @ 2.45
Spread trade: Sold 10 USO April 79-80 put spreads @ 0.35
Short Put Spread - Play #16 (Education > The Options Playbook > The Plays > Play #16)
A short put spread obligates you to buy the stock at Strike Price B (80) if the option is assigned but gives you the right to sell stock at Strike Price A (79). A short put spread is an alternative to being short the 80 strike put. In addition to selling a put with Strike B (80), you're buying the cheaper put with Strike A (79) to limit your risk if the stock goes down. But there's a tradeoff - buying the put also reduces the net credit received when running the play.
The term "Short" in this case refers to the premium - as in this is a credit trade. The credit is calculated by subtracting the two put prices, as one is a cash inflow and the other is a cash outflow. The credit is 2.45 - 2.10 = 0.35.
The break even point for the spread: 80 - 0.35 = 79.65. If the stock is above 79.65, the overall position will be profitable. If the stock is below 79, or between 79 and 79.65, the trades netted together will result in a loss.
BREAK-EVEN AT EXPIRATION
Strike B (80) minus the net credit received (0.35) when selling the spread.
THE SWEET SPOT - the floor for the stock price
You want the stock to be at or above Strike B at expiration, so both options will expire worthless.
MAXIMUM POTENTIAL PROFIT
Potential profit is limited to the net credit you receive when you set up the play, 0.35.
MAXIMUM POTENTIAL LOSS
Risk is limited to the difference between Strike A and Strike B, minus the net credit received.
80 - 79 = 1.00 - 0.35 = 0.65
MARGIN REQUIREMENT
In most cases, it is equal to the maximum loss, 0.65.
TRADE DISCUSSION and RESEARCH
USO is the ETF that is based on the price of crude oil. It has been in a strong, tight uptrend since early February. Thus a put credit spread - which is a somewhat bullish position -appears to reflect a view that this trend will continue. But, let's take a close look at the probabilities and expected return.
In this spread, as noted above, the gain is $35 and the risk is $65, through April option expiration. The margin requirement is $65 as well, so the trader is risking 100% of his investment. Suffice it to say that any position in which you can lose your entire investment should only be entered into with a small, fixed percentage of your available trading account. Typically, I wouldn't advise putting more than 3% to 5% of my available funds in any one position like this, but this is ultimately left to your judgment as a self-directed investor. So, if you have a $20,000 trading account, and this position requires $65 in margin, then you'd establish the following quantity of spreads (using 5% account risk):
Quantity = $20,000 x 5% / $65 = 15 spreads
(at 3% account risk, you'd sell 9 or 10 of these spreads in a $20,000 account)
Now, let's talk about whether this is a good position or not. Let's look at the profitability via a simple profit graph (Figure 1). These graphs are drawn with the software called Expected Return Calculator (copyright 2007, McMillan Analysis Corp.). It can be purchased as stand-alone software to run on a PC. An expected return analysis takes into account both profitability and probability. The black line shows the profits and losses for one spread at April expiration, while the blue line shows them on March 17th - a date which I arbitrarily selected. I have not included commissions in this analysis.
Click here for a larger image.
At the prices shown above, with the stock at 86.92 on March 12th, the implied volatility of the puts sold was about 49%. That seems very high, so perhaps these puts were sold when the underlying was lower.
This profit graph in Figure 1 uses a volatility estimate of 30% for USO. That's right in line with 10-, 20-, 50-, and 100-day historical volatilities. It may surprise you to see that the 3-standard deviations move in a month, at that volatility, could take USO as high as 122 or as low as 65, roughly. Of course, the probabilities of those extreme moves are small, but they are within the 3-standard deviation envelope.
As a result, the expected profit from this put spread is $17.15 - only about half the initial credit. When you subtract two commissions (which you'll spend even if the spread expires worthless), the expected profits are even loss.
These expected profits would drop if volatility increased. Currently, the puts are trading with an implied volatility of about 40%, not 30%. If one were to use that 40% volatility for the analysis, the expected profit drops to $10.44! Ouch! After commissions, there wouldn't be much profit left at all. Of course, the maximum profit remains at $35 before commissions, and that can still be made as long as USO is above 80. But, in a totally neutral (lognormal) market, USO has a significant chance of dropping below 80 by April expiration.
Perhaps it would be more illustrative to merely look at the probabilities of success, using our Probability Calculator 2006. We'll use these assumptions:
USO = 86.51 (closing price, March 14th)
Volatility estimate = 30%
Furthermore, we'll use a "fat tails" price distribution and assume that there is a positive bias to this stock since it's in a strong uptrend.
Two kinds of probabilities can be calculated: 1) the probabilities of where the stock will be at April expiration, and 2) the probabilities of where the stock will be at any time between now and April expiration. I call these the 1) "end point" and 2) "ever" probabilities.
For example, the probability that the stock closes below 80 at April expiration is 21.4% (perhaps higher than you might have thought). But the probability that the stock ever trades below 80 between now and April expiration is 35.0%. In other words, there is about a one in three chance that the stock will drop below 80 at some time between now and expiration.
Here is the full set of probabilities, using a volatility estimate of 30%:
Using vol estimate of 30%:
End Point Probability "Ever" Probability
Probability below 80: 21.4% 35.0%
Probability below 79: 17.6% 29.2%
At this 30% volatility, there is about a 17.6% chance of losing all of your money at expiration. But what happens if we up the vol estimate to 40% -- in line with the implied volatility of the puts?
Using vol estimate of 40%:
End Point Probability "Ever" Probability
Probability below 80: 28.4% 47.9%
Probability below 79: 24.8% 41.6%
Now, at this 40% volatility estimate, there is nearly a 25% of losing your entire investment.
For my purposes, that's too much risk for a fixed profit potential type of trade like this. Rather, I'd like to see only about a 20% chance or less of the stock ever being able to fall below my short strike at any time between now and expiration (the "ever" probability).
In order to get that, using the 30% vol estimate, you'd want to sell the April 77 strike. But if you up the vol estimate to 40%, you'd want to sell the April 75 strike. You'd then complete your put spread by buying an April put with a lower strike - with probably more than a point difference in the strikes; otherwise, there wouldn't be much credit at all in the put spread. You might think that you don't want the extra risk of widening the distance between the put strikes, but you've accounted for a great deal of that risk by using the lower strikes in the first place. You'd have a much higher probability of making the credit you sell the spread for, as opposed to the above spread, where there is higher chance that you won't realize the maximum profit.
Also, note the "ever" probabilities above. Since this position has fixed risk, it is not necessary for the trader to make any interim or follow-up adjustments to the trade, even if the underlying falls below 79. However, the psychological pressure to do something will increase if one sees USO trading below 79. When one trades because of psychological pressure, he often makes mistakes. Furthermore, if the spread is removed early, two more commissions will be spent. These "ever" probabilities show there is a 30% to 40% (actually, 29.2% to 41.6%) chance of that scenario occurring - more aggravation than I'd want to have in a put credit spread.
Summary
In my opinion, this position does not have enough profit potential to justify the risk. I would suspect that the trader estimates that there is far less risk of the spread realizing its maximum loss, than shown by the above probability calculations. If oil remains neutral to bullish, he'd be right, of course. But using a "neutral" or only slightly upward biased distribution, there is a non-trivial chance of this position losing its entire investment.
Thanks for sharing your trade with us. I look forward to seeing how it plays out in the market.
This comment was prepared on 3/15/08.
President
For a list of previous All-Star Trades, please click here.
Options involve risk and are not suitable for all investors.
Please read Characteristics and Risks of Standardized Options.
While implied volatility represents the consensus of the marketplace as to the future level of stock price volatility or probability of reaching a specific price point there is no guarantee that this forecast will be correct.
Any strategies discussed and examples using actual securities and price data are for educational and illustrative purposes only and do not imply a recommendation or solicitation to buy or sell a particular security or to engage in any particular investment strategy. In reading content in the Community, you may gain ideas about when, where, and how to invest your money. Although you may discover new ideas or rationale that may be compelling, you must ultimately decide whether or not to put your own money at risk. Consider the following when making an investment decision: your financial and tax situation, your risk profile, and transaction costs.
The tools utilized above are not intended to be a substitute for your own judgment. You are solely responsible for evaluating the merits and risks associated with the use of investment tools before making any investment decisions. TradeKing is not responsible for any losses that occur from such investment decisions.
Lawrence G. McMillan has a professional business relationship with TradeKing.
