Tuesday, March 9, 2010

Buying Basic Spreads – Part 2

One thing that I neglected to mention in the last post (Buying Basic Spreads - Part 1) about hedging by buying a put spread is that you can use similar strategy if you are short the stock but instead buy a call spread to protect yourself against a short term spike if your longer term outlook for the stock is bearish. However, and this leads to the next topic, you could also purchase a spread to capture short term moves in a speculative sense. Obviously either bullish or bearish speculative positions can be established by purchasing call or put spreads respectively. In my opinion, this can be a great strategy for swing traders. In other words, and this is heavily dependent on your particular broker's margin requirements and your risk parameters, you might be able to significantly leverage your opinion by purchasing a basic spread for several days or weeks as compared to purchasing or shorting a stock.

For this example we will take a look at Cummins Inc (CMI), which, although finishing down on Monday, is trading at levels not seen since September 2008. Again, strike selection is highly dependent on expectations of movement and the time frame that that movement might occur in. Let's assume that your expectations are for continued strength over the next month and a half. While you have a number of choices as far as strikes are concerned, since the stock has $2.50 strike intervals up to $65, we will examine the 60-65 and 62.5-65 call spreads.

The former could have been purchased near yesterday's close for $2.00 and the latter for $.85 (as always assuming a bid to ask transaction with no price improvement). In both cases your maximum loss is limited to premium paid and the maximum gain is capped at the difference between the strikes less premium paid or $3.00 and $1.65 respectively. After our usual assumption of 2 weeks passing and implied volatility remaining unchanged, should the stock drop to $57 the spreads would be theoretically be worth $.52 and $.26. On the other hand should CMI rise by $3 over the period, the theoretical values would be approximately $2.65 and $1.11 respectively. While assuming an unchanged level of volatility is not necessarily a reasonable expectation, it serves to help understand the price and time impact on the value of the options. Also, and this is why I mention basic spreads as a choice for swing traders, if you are long and wrong and the stock is at $57 and decide to close the trade you have lost $1.48 on the 60-65 spread compared to the $3.00 which that would have been lost if you were long the stock. On the other hand, if you are right you make only $.65 compared to $3.00 being long the stock. The point I wish to make with regard to short term trading is that, assuming a 50% margin requirement (margin being just another form of leverage and may vary depending on your agreement with your broker), you would have tied up $30,000 in capital on a 1000 share trade compared to $2,000 to own the spread 10 times. Because of the additional leverage, percentage gains and losses are also magnified, resulting in an approximate 75% loss on the down side in the spread versus a 10% loss from owning the stock. Contrast that to a 32.5% gain on the spread and a 10% gain on the stock should CMI move to the upside. Obviously, commissions, slippage and other factors may influence total return, but that is why this is an example. Additionally, I am not necessarily advocating for this strategy but it is worth a consideration if you engage in this type of trading. Like any form of speculation or investing you must be comfortable with the risks associated with a transaction and understand them fully.

One thing that we have not covered is the impact of changes in implied volatility over the course of time; we will take a look at that in the next post on the subject.

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