An option strategy everyone should know

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When you read this…

“Sell 10 XYZ May 70 puts @ $2.00 and Buy 10 XYZ May 65 puts @ .50 for a net credit of 1.50.”

Does it sound like a foreign language?

Don’t worry, let’s walk through this step-by-step.

First of all, this trade is called a “spread” or “vertical.”

This is a trade that involves selling an expensive option (to collect the premium) while at the same time buying a cheaper option (to limit losses if the trade goes bad.)

When the trade is made, the seller receives a net credit of $1,500 ($2 points premium received – $.50 premium paid).

Keep in mind that ONE contract = 100 shares of the underlying stock.

So,  10 contracts [100 shares per contract] x $1.50 per contract = $1,500 credit.

It’s important to realize that the seller is actually receiving money, or a credit, when he makes the trade.  

That is the opposite of what you are probably used to when you buy a stock or option. When you make that trade, you are paying a debit to make the trade. 

Now, let’s look at a visual of how the trade works for both profits and losses.

As shown in the graph above, the trade will profit if the market price of XYZ closes above $68.50 at expiration. 

The trader will receive the maximum profit of $1,500 at $70 or above.

Conversely, he will lose money if the price of XYZ goes below $68.50. 

It is important to understand that the trader could lose up to $3,500 if XYZ closes at $65 or below, at expiration, which is more than the possible profit of $1,500.

Why would anyone make this trade, you might ask?

It is because selling this trade to someone else has a high probability of working in favor of the seller (sorry, buyers!).

Here is a graph showing how the profit/loss payouts look like depending on where the stock closes…

If you made it this far, you are well on your way to becoming an option-selling ninja! 🥷

We have the mechanics of the trade down, now let’s look at the different scenarios that could happen:

Scenario 1: The stock drops significantly and closes at $62 on option expiration.

If this happens, the trade will be exercised on the 65 puts, and sell short 1,000 shares of XYZ stock for $65,000

At the same time, your short 70 puts will be assigned, and you will be required to buy back your short position for $70,000 to close.

This sounds scary at first, but realize these are two offsetting positions. If the trader decided to hold the trade all the way to expiration, these two trades would offset each other since they are both “in-the-money.”

The difference between the buy and sell price is -$5,000 🤮. 

However, because the trader brought in $1,500 as a credit when the spread was established, his net loss is only $3,500.

This will be the case at any price below $65.

Scenario 2: The stock drops only slightly and closes at $67 on option expiration.

If this happens, the trade won't exercise the 65 puts, because they're out of the money

However, the trader is short 70 puts which will be assigned.  The trader will be required to buy 1,000 shares of XYZ at a cost of $70,000.

The trader can then sell your shares at the market price of $67, for $67,000.

The difference between the buy and sell price results in a loss of $3,000.

However, because the trader brought in $1,500 when the spread was established, the net loss is reduced to only $1,500.

The loss will vary from zero to $3,500, at prices from $68.50 down to $65.

Scenario 3: The stock closes at exactly $68.50 on option expiration

If this happens, the trader will not exercise the 65 puts, because they're out of the money.

However, the short 70 puts will be assigned, and the trader will be required to buy 1,000 shares of XYZ at a cost of $70,000.

He can then sell his shares at the market price of $68.50, for $68,500.

The difference between your buy and sell price results in a loss of $1,500.

However, since the trader brought in $1,500 when the spread was established, the net loss is zero.

Scenario 4: The stock rises only slightly and closes at $69 on option expiration.

If this happens, the trader won't exercise the 65 puts, because they're out of the money (that means they are worthless).

However, the short 70 puts will be assigned, and the trade will be required to buy 1,000 shares of XYZ at a cost of $70,000.

The trader can then sell his shares at the market price of $69 for $69,000

The difference between the buy and sell price results in a loss of $1,000.

However, because the trader brought in $1,500 when the spread was established, the net gain is $500.

This gain will vary from zero to $1,500, at prices from $68.50 up to $70.

Scenario 5: The stock rises and closes over $70 on option expiration.  If this happens, the trader won't exercise the 65 puts, because they are out of the money

The short 70 puts won't be assigned, because they're out of the money as well.

In this case, all the options expire worthless, and no stock is bought or sold.  This is the ideal outcome because the seller is always hoping the trade goes to $0.  That is when he collects the maximum profit.

Since the trader brought in $1,500 as a credit when the spread was established, the net gain is the entire $1,500 as profit.

This maximum profit of $1,500 will occur at all prices above $70.

Put spreads are sold when a trader thinks a stock is going to trade higher over a period of time, or even sideways. The power of time decay works in favor of the seller in that case, and the value of the options gradually decreases (which is good for the seller).

If the seller is wrong, and the stock goes much lower, this trade also creates a “safety net” and limits the possible losses at a certain point.  Having the ability to set up a high probability trade like this that has a defined amount of downside risk, as well as a known amount of possible profit makes it an ideal trading strategy for many trading situations.

Hope you stayed with me and had some time to digest this! 

This is exactly the type of teaching I provide members in my flagship options selling service, Alpha Hunter.

I have LIVE training on this every week where you can bring your questions and we record these sessions for on-demand viewing 📽️.

If you want to learn more, I have a great monthly rate now available to try out my service. I’d love to have you with me!

To YOUR success,

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