Let’s say I think the stock price of WXYZ is going down. I was ready about one strategy that seems to minimize risk, the bear put spread.
I buy $11 puts of WXYZ at $0.50
I sell $10 puts of WXYZ at $0.20. This lowers my cost of the $11 puts to $0.30
Label the price of WXYZ §
p > 11 means a loss of $30 per contract but this is all front-loaded so no surprises
10.70 < p < 11 is still a loss but less and less until the breakeven point
p = 10.70 no gain or loss
10 < p < 10.70 gain of (10.7 - p) x 100 per contract
p < 10 Here it gets interesting. If the contract I sold gets exercised I get put 100 shares at $10. BUT I can immediately turn around and exercise my put that I bought and sell them at $11. With a $0.30 cost per share that means I make $70 per contract.
So as long as I can cover the $1000 per contract OR better yet my broker lets me take advantage of the T+1 to give me the 5 minutes or so I need to sell my puts I should be good right? All of the potential loss is front-loaded and there is no unexpected cost later on.
For the most part you’re right, that the maximum loss is both puts being worthless because the market price.
The scenario I’d worry about is price = $10 where it isn’t clear whether or not other buddy will sell to you at $10. You could end up with an extra set of shares and the potential loss on those is $1000. What’re the odds of that though, right?
I thought of that, but if the price is $10 I’d get put at $10 and then immediately sell them at $10 but the goal is to sell them at $11.
I think the only trick is with my brokerage if I would actually have to come up with the $1000 or if I can arrange with them to automatically exercise MY puts at $11
First of all, puts are almost never exercised early. A call option may occasionally be exercised early due to a dividend. If the value of the dividend exceeds the time value on the option, then it makes sense for a long call option holder to exercise their option to collect the dividend.
Put price premiums will increase more rapidly to the downside as there is a bias towards the upside in equity markets. So, if the price of WXYZ dropped sharply, that resulting spike in volatility would push the put price upwards, making early exercise senseless.
In your specific example, there are a couple things to consider. First of all, being assigned on a short put would result in a stock transaction which is a T+2 settlement. Second of all, the requirements of your brokerage firm most likely wouldn’t allow a spread to be placed in an account that can only cover the debit of the spread being placed with no additional equity in the account. If the spread is done in a taxable account, it would need to be a margin account, that requires $2000 in equity as an absolute minimum and many firms have higher requirements. Some firms will allow spread trading in IRA accounts, but the requirements are going to vary by firm and I highly doubt option spread trading approval would be granted in an account that did not have a reasonable account value and also some trading experience.
Option contracts are cleared through the Options Clearing Corporation, the strike prices are guaranteed. In this example, **Saint Cad ** will be guaranteed that should he exercise his long puts, s/he would receive his $11 per share. The same with the short puts, s/he would only be buying the shares at $10.
This seems like a good reason to keep most of your savings with a broker like Schwab (rather than directly with Vanguard) and do some trading. (And like Vanguard, Schwab offers a variety of low-fee index funds, both open and closed.)
The problem with this kind of strategy is in timing. If the market drops in the near term, the put spread will increase in value, but not (initially) to anywhere near the $1 difference between the strikes. So it can be frustrating if you are “too correct” on the market, because you won’t be able to take as much profit off the table as you think if the market drops quickly. In that scenario, the $10 strike that you’re short has a lot of time value, so you need the market to stay down and for time to pass before the value of the put spread will approach the terminal payoff, the $1 difference between the strikes.
What I’d say is, don’t just think about the payoff at expiration. Put the two strikes in an option calculator, leave the implied volatilities constant for simplicity, and map out what would happen to the market value of the spread with the market going down to various points at various times between now and expiration. See if you’re happy with what your p&l would be if the market drops relatively quickly. You may find you’d be making less money than you expect.
Another way to think of the bets is that you are betting that WXYZ will fall below $11 and also betting that it will not fall below $10 ! Unless you really think you can gauge WXYZ’s future price so closely, you are betting against yourself. One bet is your real bet; the other is just a hedge.
Obviously OP already understands this very well. But do you really need that hedge? Unless you’re placing a significant percentage of your total savings into very speculative investments, you probably don’t need the risk reduction. TL;DR: If you’re spending 6% of your bankroll on those puts, by all means hedge them! If, say, just 0.6% of your bankroll, I wouldn’t bother (unless you have several active bets like this).
The more you hedge your good ideas to reduce risk, the less you win when the good ideas pay off.
In this particular case, I agree with you and I’d just buy the long puts. Spreading it off may make sense with high vol stocks where the put premiums are expensive. It especially works well with a more expensive stock where you can have a much wider strike price differential than in this hypothetical.
You realize that a stock that trades at $100 is not more “expensive” than a stock that trades at $10, right? The value of a company is its market cap, not its share price.
Similarly, for a given volatility, a $95-$85 put spread on a $100 stock is exactly the same percentage price (and has exactly the same economics) as a $9.50-$8.50 put spread on a $10 stock. Multiplying everything by a factor makes no difference.