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Extremely Bullish?
A deep in the money
CREDIT SPREAD will do nicely.
If one would happen to be
extremely bullish on a stock and is expecting a nice move upward, perhaps they
might consider a deep in the money put credit spread instead of buying the stock
or overpriced call options. The objective here is to capture maximum profit
while participating in the stocks run up. The part that makes this option spread
strategy even more attractive would be the very low exposure to the downside
should this bullish opinion be wrong.
With ABC stock trading at 51 we will look at the difference in how this scenario
will play out using a straight out stock purchase compared to the deep in the
money – VERTICAL put credit spread. (Commissions are not factored in) As this
breaks down we will see how the VERTICAL PUT CREDIT SPREAD will pretty much
profit in the same manner as owning the stock outright. More importantly this
put credit spread will have a tight limit on how much it can lose on the
downside.
ABC Stock is selling @ 51 – The June 60 puts are selling @ 9.50 and the June 50
puts are @ .50
The cost for 1000 shares
of ABC stock would be -$51,000. The credit for and an equivalent position using
the credit spread will be $9000 from selling the June 60 puts for 9.50 (+9500)
and buying the June 50 puts for .50 (-500) which yields a credit of $9000. As we
can see the out of pocket for the stock purchase will be $51,000 – The margin
requirement for the spread will be $1000 (the difference between the strikes of
60 and 50 (10,000 – the 9,000 taken in on the credit spread)
Although the potential gain while owning the stock has no limit, there is no
protection on the downside should this bullish idea be wrong there remains a
huge exposure should ABC drop severely. Although the credit spreads profit
potential is limited to the $9000 taken in – it has maximum loss of $1000.
| STOCK |
ABC |
SPREAD |
| 10,000 |
61 |
9,000 |
| 9,000 |
60 |
9,000 |
| 8,000 |
59 |
8,000 |
| 7,000 |
58 |
7,000 |
| 6,000 |
57 |
6,000 |
| 5,000 |
56 |
5,000 |
| 4,000 |
55 |
4,000 |
| 3,000 |
54 |
3,000 |
| 2,000 |
53 |
2,000 |
| 1,000 |
52 |
1,000 |
| 0 |
51 |
0 |
| (1,000) |
50 |
(1,000) |
| (2,000) |
49 |
(1,000) |
| (3,000) |
48 |
(1,000) |
| (4,000) |
47 |
(1,000) |
| (5,000) |
46 |
(1,000) |
| (6,000) |
45 |
(1,000) |
| (11,000) |
40 |
(1,000) |
| (16,000) |
35 |
(1,000) |
| (21,000) |
30 |
(1,000) |
As we can see in the P&L
table - the spread yields the same profit potential as the stock up to 60 but
more importantly the maximum loss is only $1000 compared to what could happen if
ABC stock was purchased straight up. Should the bullish opinion be higher than a
10 point gain on ABC, one could adjust the spread and sell even DEEPER IN THE
MONEY PUTS such as the 65’s or 70’s depending on the opinion to capture more
potential upside profit.
Along with maintaining a tight limit on the downside, this SPREAD has a much
greater rate of return on the profit side since the out of pocket is only $1000
compared to the $51,000 cost for the stock.
Keep in mind when selling deep in the money options the chance of being
exercised upon is possible and the OPTION STRATEGIST needs to watch the pricing
compared to parity along with the OPEN INTEREST. This will keep the strategist
aware of the probability of being exercised upon. Should an EXERCISE occur the
prepared STRATEGIST is still in a good position with this SPREAD STRATEGY and if
properly prepared, will know exactly what to do to capitalize on the situation
which will be addressed in my next article.
Frank Kneipher
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