Well I hate to do it, but let’s just get the caveats out of the way right off the bat. In this article I am going to detail a position that can allow an investor to profit as long as the stock market does anything at all except fall apart between now and 10/21 (to which some may reply, “I’m just hoping it doesn’t fall apart between now and 10:21”, which in all candor, is a good point).
Still – remembering that we are presently in “caveat mode” – the purpose of this example is not necessarily to show you how to take advantage of a bottom in the overall stock market at this exact moment in time, but rather to add another arrow to your quiver as a trader and investor. For via the use of options it is possible to make money on a bullish position even if the underlying security does not advance in price. Interesting concept, no?
The Credit Spread
The position I am going to highlight is most typically referred to as a “credit spread” or as a “bull put spread.” The position involves selling one put option with a strike price below the current price of the underlying security (i.e., if the stock is trading at $61, you would look for a put option with a strike price of $60 or less) and also buying another put option with an even lower strike price (in this example, something less than 60).
When you enter the trade you take in more money from the option you sell than you pay for the option you buy, thus you receive a “credit” for the difference between the two in your account (hence the term “credit spread”). You stand to make money on this position as long as the underlying security does not decline below the strike price of the option you sold minus the credit you received (is this options stuff fun or what?). Let’s see if we can translate some of this into English with an actual example.
Picking a Bottom with SPY
Figure 1 displays a chart of ticker SPY, the ETF that tracks the S&P 500 Index.
Figure 1 – Is ticker SPY in an uptrend, a downtrend or a trading range?
click to enlarge
Now chart patterns (and human nature) being what they are, some investors will look at this chart from the far left to the far right and see a market that is “declining sharply.” Others will look at the last several weeks of activity and say that the market is “stuck in a trading range.” Others still will see a series a series of lows and will conclude that the market is due “to bounce” to higher ground. I will let you make your own decisions here. The bottom line though is that there is a way to make money if SPY bounces higher, stays stuck in a range or even if it declines a little between now and October option expiration.
SPY Credit Spread
Figures 2 and 3 display a bull put credit spread using put options on SPY that involves:
Selling 12 October 108 puts at $2.72
Buying 12 October 106 puts at $2.31
Figure 2 – SPY Bull Put Spread by the numbers
click to enlarge
Figure 3 – Risk curves for SPY Bull Put Spread
click to enlarge
A few things to note:
-The August low for SPY was $110.27
-The breakeven price for this position is $107.59
-The maximum profit potential is $492.
-The maximum risk is $1908, however, this can only be realized if, a) we hold the position until expiration and, b) SPY is below 106 at that time. So will resolve immediately not to let that happen.
Managing the Position
Once this position is entered there are two key price levels to keep in mind. The first is the previous low for SPY of $110.27. This is a support level and as long as SPY holds above this price everything is hunky dory. One risk control possibility is to exit the trade if $110.27 is exceeded on the downside. Let’s use $109.99 as an arbitrary stop loss price. The worst case loss if this happened prior to expiration is roughly -$320 to -$390.
The other alternative is to use the breakeven price of $107.59 as a fail-safe exit point. If this price is hit prior to expiration the maximum expected loss would be approximately -$540 To -$560.
Under any other circumstance, as long SPY close on October 21st at 108 or above, the maximum profit potential of $492 will be realized.
So the question to answer regarding risk control for this position is, do you want to:
-Use a tighter stop of 109.99 (which has a higher probability of being hit) and risk $320 to $390, OR;
-Use a wider stop of 107.59 (which has a lower probability of being hit) and risk $540 to $560.
For the record, there is no right or wrong answer – only personal preferences.
The real key to this particular trade – and for any bull put spread – is that the stop-loss price (in this case either $109.99 or $107.59) is below the recent low, which represents the most recent support level. If we felt compelled to cut our loss at some price above the recent low then a simple retest of the lows would force us to be stopped out and lose money. So bottom line, the further away you can place a stop-loss order (without exposing yourself to excessive dollar risk) the better.
So in this example we are essentially either:
-Risking $320 to $390 to make $492 as long as SPY declines no more than 5.7% in 39 days,
-Risking $540 To make $560 as long as SPY declines no more than 7.8% in 39 days, OR
So the obvious question on most minds is simply “will the August low hold?” For the record, historically September has been the worst month for the stock market and October is also referred to as the “Month of the Crash”. So there are plenty of reasons to avoid altogether trying to pick a bottom in the stock market right here. So again, I am not suggesting that everyone rush out and enter a bull put spread in SPY at this exact moment.
The real purpose of this article is simply to highlight the fact that if one is so inclined as to attempt to pick a bottom it is possible to:
-Enter a bullish position
-That can make money if the underlying security rises, remains unchanged or even declines slightly
-Without “betting the ranch”
-While putting the odds in your favor
But as with any position the one key step that is up to each trader to decide upon and implement is reasonable risk control. In other words, don’t ask “what happens if I’m right?” Instead ask (and answer specifically) the question “what happens if I’m wrong?” Then put a plan into place and execute it ruthlessly if your worst case ultimately plays out (as it invariably will from time to time).
And who knows, maybe you'll get lucky and the underlying security will go absolutely nowehere. And you will achive your maximum profit. What a concept.