By Larry Benedict, editor, Trading With Larry Benedict
Option traders commonly use spread trade strategies to profit.
That has a lot to do with their versatility.
You can use spread trades to capture a wide range of market conditions – like when the market is gently rising or falling (or even if it’s just trading sideways).
A spread trade involves the simultaneous buying and selling of call (or put) options with different strike prices and the same expiry date.
We looked at the bear put spread strategy earlier this year.
And one reader asked a very smart question:
Hi… you described the bear put spread with several scenarios of the stock price going down. Could you also describe what we might do if the price goes sideways or up? When do we close the spread position, and when do we let it expire worthless?
– Lance W.
Thanks for the question, Lance. Let’s get straight into it…
A Bear Put Trade in Action
To briefly recap, you typically use a bear put spread if you are bearish on a stock but are not convinced that it will fall heavily. (If you thought that it would plummet, then you would just buy a put option by itself.)
The trade involves buying a higher-priced put option (“A” on the chart below) while selling a put option at a lower strike price (“B”).
Please note that this chart of Tesla (TSLA) is only for illustrative purposes and is not a trade recommendation.
Tesla (TSLA)
Source: e-Signal
The second leg is further away (below) than the current stock price. So your bought put option will cost more than the premium you receive from selling the written put option.
The reason for adding the second leg is that it lowers your cost compared to just buying the put option by itself. And in doing so, it helps improve your breakeven position on the trade.
If your analysis is right and the stock price falls, you typically close out your bear put trade before expiry.
But what happens if the stock price goes sideways or up instead of down?
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When to Close the Trade
One of the major things you need to remember with options is that the clock is always ticking toward expiration.
While that might be handy when you’re selling an option, it works against a bought put option.
Since we pay more for the bought put leg (“A”) than we receive from the sold put (“B”), time decay plays an even bigger factor in this strategy. Time decay means that your options lose value as they get closer to expiration.
That’s why you need to monitor your position closely.
If the position starts to go against you, you need to reassess the likelihood of your planned move coming off within your time frame.
If the chances become increasingly slim, it is often best to close out the trade immediately. Remember that time decay accelerates the closer you get to expiry.
Another way to play your exit is to set a stop loss based on a fixed percentage.
For example, if your spread value drops by 20% (or whatever percent you choose), that can be a trigger to exit the trade.
Or if you’re very confident that the move you’re expecting just needs a little more time, you can “roll out” your position.
This means you’ll close out your initial position at a loss and open a new position with a later expiration date.
Finally, if your spread trade hasn’t worked out, you may choose to let the position expire worthless if the cost of closing the trade (broker commissions and other charges) exceeds the value of your position.
Regards,
Larry Benedict
Editor, Trading With Larry Benedict
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