The equity and options markets were very quiet yesterday and are again today, as expected in the days leading up to the Christmas holiday. In my Monday morning market update, I wrote about the potential for a slow week and extreme decay of options because the market will be closed for several days for Christmas and New Year’s. I also mentioned that there are a couple of strategies that traders can use to sell volatility and collect this decay.
Over the course of the next couple of days, I will review some of these more advanced strategies.
As I have always said, part of what I see in my role at Cabot Options Trader and Cabot Options Trader Pro is to take the “beginner” options trader to “intermediate,” and the “intermediate” options trader to “pro.”
First, I want to review the concept of Time Decay. Options are a wasting asset whose value declines over time. As the option get closer to its expiration, if it’s not in-the-money, its time value declines as the probability of that option finishing in the money is reduced. For example, a Netflix option with six months until it’s expiration may lose $0.03 of value every day. However, as the option gets within a couple of days of expiration, and the probability of the option finishing in-the-money declines, the option may lose $0.25 of value every day.
With that in mind, and having discussed and used buy-writes frequently, I want to focus on three “intermediate” strategies in the coming days. The first strategy I will look at is a Bull Put Spread.
Selling a put spread, also called a bull put spread, is a short volatility/bullish trade that makes money if the stock goes up, doesn’t move, or doesn’t go down significantly. For example, if a trader believes Apple has pulled back too far and won’t continue to fall, or won’t fall dramatically, he might execute a bull put spread.
Here’s an example using fictional stock XYZ.
XYZ is trading at 95. You could theoretically sell the 85/80 bull put spread for $1. To execute the trade, you would:
Sell the 85 Puts,
Buy the 80 Puts,
For a total credit of $1.
Here is a graph of the trade at expiration:
As you can see in the chart, you’d make $1, or $100 per spread, if the stock stays above 85 at the spread’s expiration. Essentially, with XYZ trading at 95, as long as XYZ does not trade lower by $10, you will collect the $1 per spread.
Your breakeven on the trade is 84.
If XYZ closes at 80 or below, you will lose $4, or $400 per spread.
If XYZ is trading between 80 and 85 on expiration, you will need to take off the trade before the spread expires, so that you are left with a stock position.
I like this strategy because your risk is capped and you make money whether the stock goes up, doesn’t move, or doesn’t make a dramatic move to the downside.