The Nuts and Bolts of Alternative Option Trading
- Written by Carley Garner
Bear Put Spread with a Naked Leg
Buy a Close-to-the-money Put
Sell an Out-of-the-money Put
Sell an Out-of-the-money Call
When to use a Bear Put Spread with a Naked Short Call Option?
- You think the market will go down but buying put options outright are expensive
- The goal is to purchase a close to the money put for very little cost
Bear Put Spread with a Naked Short Call Option Profit Profile
- Profit is limited to the difference between the strike prices of the long put and the short put plus the net credit or minus the net debit
- At expiration the breakeven is equal to the long put strike price plus the net amount paid for the spread
- BE = Long Strike Price - Net Premium Paid (if a debit)
- RBE = Short Put Strike Price + Net Premium Collected (if a credit)
What is at Stake?
- Risk on the upside (short call) is theoretically unlimited
- The market trading above the short call is equal to being short the futures from the call strike price
- At expiration if the market is between the long put and short call you lose the net paid for the spread if executed at a debit. If executed as a credit, the trader keeps the premium collected
You have likely heard about the complications associated with trying to pick market tops, the bear put spread with a naked leg is one way of attempting to do so while giving the market some breathing room. This trade is capable of benefiting from a price reversal, but if the strike price of the naked short call is placed appropriately the risk to the trader at expiration may be considerably above the current futures market price.
I believe that this trade is best used during times of extreme price moves and high volatility. Executing it under other circumstances may increase the odds of a compromising scenario regarding the short call option.
Looking at the next figure, you will see how a typical bear put spread with a naked leg may be constructed. As the Euro rallied to an new all time high in mid-July 2008 a trader may have been able to sell the 163 call while simultaneously purchasing the 157 put and selling the 154.50 put for a net credit of 15 ticks or $187.50 before considering commissions and fees.
Because this trade was executed at a credit, it is capable of making money at expiration at any point below the reverse breakeven point of 163.15. This was figured by adding the net credit to the strike price of the short call option. Below 163.15 but above the strike price of 160 the trade is profitable in the amount of the difference between the RBE and the strike price minus the futures price. For example, if at expiration the futures price is 163.05, the trader would still be profitable in the mount of 10 ticks or $125. To simplify, the only way that this trade can be a loser at expiration is if the futures prices is above 163.15; however, the risk is unlimited above the RBE of 163.15.
The maximum profit on the trade is limited to the difference between the strike price of the long put and the short put, in this case 157 - 154.5 and is equivalent to $3,125 ($12.50 x 250). The maximum profit is achieved if the futures price is trading below the strike price of the short put at expiration, in this case it is 154.50.