Explore Your Options
| Got a question about options? Tom Gentile is the chief options strategist at Optionetics (www.optionetics.com), an education and publishing firm dedicated to teaching investors how to minimize their risk while maximizing profits using options. To submit a question, post it on the STOCKS & COMMODITIES website Message-Boards. Answers will be posted there, and selected questions will appear in future issues of S&C. |
Tom Gentile of Optionetics |
MAX PROFIT ON A BEAR PUT SPREAD
On March 30, I entered a bear put spread on XYZ using January 2007 leap options. With XYZ near $451.00 a share, the spread consisted of buying a 450 put for $45.90 and selling a 440 put for $40.40. According to my calculations, the maximum profit is $4.50 per spread if XYZ falls below 440. However, on April 4, I checked the trade and found that XYZ was below the 440 strike price. My understanding was that I could close the trade below the 440 strike for the maximum reward of 450 (minus commissions). Yet when I did the math, it did not all add up. What happened?
The trade's analysis is correct in many respects. A bear put spread is created by buying a (long) put and selling a (short) put with a lower strike price. This trade will generate profits if the price of the underlying asset falls. The spread is similar to buying a put, but the sale of the short put helps reduce the cost of the trade. This is a popular strategy for playing a market to the downside.
The cost of the bull put spread is equal to the premium paid for the long put minus the premium received for selling the short put. In this case, the trade costs $45.90-$40.40 or $5.50 per spread multiplied by 100 ($550 plus commissions). The maximum profit is equal to the difference between the two strike prices minus the cost of the trade -- in this example, 450-440 -$5.50, or $4.50 per spread ($450 minus commissions). If the spread isn't closed out and the price falls below $440 at expiration, the short put will be assigned, forcing the spread holder to buy the underlying asset at $440. However, the long put can be exercised to unload the position at $450, netting a $10 profit per share minus the cost of the trade.
However, options with significant time value remaining will not be assigned. Even if XYZ falls below the lower strike price prior to expiration, there is no reason for the short put to be assigned. With the January 2007 leaps, a lot of time value remains in both options. There is no reason to expect assignment, and the difference between the two premiums will not be enough to yield the maximum profit potential.
However, if the stock stays at or below 440 during the remaining nine months of life in the options contract, the spread will gradually widen to maximum profit. To conclude, you are correct that the maximum profit of the bear put spread occurs if XYZ falls below $440, but it must also happen closer to expiration when the time value of the options has fallen to zero. When expecting a bearish move in the near term, consider using options with fewer months left until expiration. Keep in mind that, although it won't yield the maximum possible profit potential, you can still make money by closing out the position prior to expiration.
ISE SENTIMENT INDEX
I saw that the International Securities Exchange (ISE) has a new sentiment index. Do you know how is it used?
The ISE Sentiment Index (ISEE) is a tool to track the buying and selling of puts and calls on the exchange. The ISE is now the largest US stock options exchange. The sentiment index is like a put/call ratio, but with a few important differences.
Put/call ratios have existed for some time and are used to track the relative amounts of put and call volume in the market. For example, the Chicago Board Options Exchange (CBOE) put/call ratio is one of the more widely watched ratios. It is computed as the day's put volume divided by call volume. So if 800,000 puts and 1,000,000 calls traded on the exchange that day, the ratio is 0.80 (800,000/1,000,000).
High put/call ratios indicate that puts are active. Low readings indicate that call options are seeing relatively high volume on the CBOE. Put/call ratios are also used to track the options activity related to specific stocks and indexes. For example, the Standard & Poor's 100 ($OEX) put/call ratio is another widely watched indicator. Both the OEX put/call ratio and the CBOE put/call ratio can be found at www.cboe.com.
The ISEE is different. It measures the day's call purchases on the ISE divided by put purchases multiplied by 100. Put/call ratios consider only volume, while the ISEE looks at purchases only. If 800,000 puts and one million calls were bought on the exchange that day, the sentiment index would be 125. High readings from the ISEE indicate high relative levels of call buying, while low readings suggest increasing levels of put buying (relative to calls).
Both the ISEE and the put/call ratios are used as contrary indicators to gauge relative levels of bullishness or bearishness among traders. When the ISEE reaches extremes (200+), it indicates that investors are becoming bullish and buying twice as many calls as puts. If so, it's time to trade cautiously because investors might be too optimistic. The market is overbought. On the other hand, when the index falls to low readings (125 or less), it indicates the opposite -- investors are becoming more cautious and aggressively buying puts. At those times, the contrarian-minded investor will become more bullish. The latest readings from the index, along with 10- and 21-day moving averages, can be found at www.iseoptions.com.
Originally published in the June 2006 issue of Technical Analysis
of STOCKS & COMMODITIES magazine. All rights reserved.
© Copyright 2006, Technical Analysis, Inc.
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