Q&A
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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