by Jon Najarian

You can use spreads to play the short side of the market when you’re bearish on a stock, betting that the market will decline, or simply to protect your holdings, whether they are individual stocks or mutual funds.  This strategy uses the put spread.

Let’s say you’ve selected a stock after doing your homework, and you decide that the odds of the stock trading lower are greater than the odds of it trading higher.  One way to play your hunch would be to buy a put spread.  When buying a put spread, I lock both the maximum loss and the profit potential.  For example, on a 10-point put spread, the most I can lose is the amount I paid for the put spread, but the profit potential, is the amount I paid subtracted from the strike price differential.  For instance, if I paid $2.75 a share for a 10-point put spread, my maximum profit would be $10 minus $2.75, or $7.25 per spread.  Ideally, I want to have at least a 2-to-1 ratio.  That means for the times that I’m right, I’m going to be rewarded at least twice as much as the amount I’ll lose when I’m wrong.  Adhering to this kind of ratio is the essence of risk control and money management.

Below is an example of how a put spread works: Let’s say eBay is trading at $150 a share.  I decide to buy the $150 put and sell the $140 put, for a $10 spread.  If I pay $9 for the $150 put and sell the $140 put for $6.50, I’ll pay a net of $2.50 for a 10-point spread.  For one contract (equivalent to 100 shares), you would pay $250 per spread, which is also the maximum loss, and stand to reap a maximum profit of $750 per spread.

Long 1 Oct 150 Put, Short 1 Oct 140 Put

Now, even if eBay went to $200 a share – the exact opposite of what I wanted to happen – I would still lose only $250.  Overall, I’m risking $250 to make $750 per spread – a three-to-one reward/risk ratio, which I consider to be great odds in my favor.  And, I’m controlling the downside of what is otherwise a very volatile stock, which could be hard to borrow if I wanted to short it.  At the same time, I would be in a position to profit handsomely if the stock trades the way I think it would and declines in price.

Put Spread
eBay trading at $150 a share
Buy $150 put and pay $9 premium
Sell $140 put and collect $6.50 premium
Maximum Loss: $2.50 a share
Maximum Profit: $7.50 a share

If eBay declines in price to $140 a share, profit on the $150 put is $10 a share, minus the $9 premium, for a net profit of $1.00 a share, or $100.  However, since the $140 put expires worthless, I keep the $6.50 a share premium, for a total profit on the trade of $7.50 a share ($1.00 plus $6.50), or $750 per spread.

If eBay declines to $130 a share, I make a $20 profit on the $150 put, minus the $9 premium for a net profit of $11 a share.  The $140 put I sold is exercised, requiring me to buy stock for $140 when the stock is trading at $130.  I lose $10 a share, which is partially offset by the $6.50 a share premium I collected, for a net loss on that trade of $3.50.  My overall profit on such a spread trade is $7.50 ($11 minus $3.50), or $750 per spread.

If eBay rises to $160 a share, the $150 put I bought expires worthless and I lose the $9 premium.  The $140 put I sold also expires worthless and I keep the $6.50 a share premium, for a total net loss of $2.50 a share, or $250 per spread.

For more sophisticated investors, there is another strategy that involves selling puts as a partial surrogate for owning the stock.  Let’s say you like Xerox, which has sold off rather sharply over the past few months, declining from $60 a share to around $25.  As a result, you consider the options to be very under-valued, as the collapse pumped up volatility in both call and put options.  One way to invest would be to buy the shares outright at today’s price and wait for them to appreciate in value.  Or you could sell the at-the-money puts that are a few months out and collect a premium of, say $3 a share.

The buy of those puts could be someone who wants to lock in downside price protection by buying put options.  For example, the buyer could purchase April $25 put options, which would protect his or her investment if the stock declines below $25 a share.

Let’s say that you on the other hand, are bullish on the stock.  You believe there is little chance, if any, that Xerox will trade below $25 a share.  By selling the $25 puts, you get to keep the $3 premium if the stock behaves as you anticipate and trades at least at or above $25 a share.  Interestingly, in this scenario both you, as the seller of the put, and the buyer, looking for downside protection, are both bullish on the stock.  The stock buyer probably has a long-term bullish bias for XRX, while the put seller is simply thinking the stock is oversold and the options overpriced.