Friday, March 5, 2010

Buying Basic Spreads – Part 1

Today we are going to begin talking about buying 1-to-1 spreads. These can be done as narrowly or as widely as you like and for nearly any time frame. What is nice about buying spreads is that your ultimate risk and reward is clearly defined on entry: the most you can lose is the premium paid, and the most you can gain is the difference between the two strikes less premium paid. While this strategy can be used effectively for short term, risk controlled speculation; it can also be used to reduce hedging costs.

In the latter sense, put spreads can bought in lieu of a straight put purchase if one is concerned about a near term pull back, i.e. you need a little insurance. Let's say you were fortunate enough to pick up Consolidated Graphics (CGX) sometime in the last year (the stock has more than tripled since the low last March) but you are still long term bullish. None the less the stock has had a tendency to return to its 50-day SMA every few months and you are concerned that that time may be coming. This is not a bearish call on CGX, but simply an example.

Yesterday's the stock jumped nearly 4% to close at $46.17. Volume has been very strong since the stock reported a second consecutive quarter of blow out earnings (at least relative to the average of the two analysts that Yahoo! reports as covering the stock) in early February. None the less, there has been a month of apparently strong accumulation. You might feel that interest may be starting to wane and would like a little protection for the short run. As always depending on your outlook, you might choose either March or April options. Since, in this case there are two weeks to March expiration and the 40 puts are no bid, we'll take a look at April. CGX's option markets are fairly wide and not very deep (there is a good probability of price improvement, but that is a discussion for another time) so we are stuck with the bid ask spread for argument sake. The Apr 45 Ps were offered near the close at $2.40 and the 40 Ps were $.65 bid; so you could purchase the spread for $1.75 rather than purchase the 45 Ps alone. Again, our hypothetical expectation is for a short term pull back with a longer term positive view. This provides us with a less expensive way to insure a long position understanding that the greater coverage, at higher cost, of an outright put purchase is sacrificed.


By using April options we have also bought some time, however, should the pull back occur sooner rather than later, it may be worth considering removing the position. For example, let's say that after two weeks have passed and implied volatility has remained uncharacteristically constant at approximately 43 while the price has descended to $41, the spread would now be worth roughly $3.00. Is this the target you had in mind as far as a pull back? Or is it worth holding a little longer to remain hedged for another dollar on the down side? Whatever your decision, should you hold the position through expiration you will receive an automatic exercise if the stock closes between 40 and 45, so be sure to close it out if you want to hold onto your stock. May sound obvious, but you would be amazed.

As I have moved through this explanation, I realize that it is difficult to cover all aspects of an example, so feel free to throw a question my way if you need further clarification or expansion on any of the posts. We'll continue to examine basic spreading next time.

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