The Options Insider - Your Inside Source for Options Information

Bull Put, Wright Or Wrong? - Part One

Observing The Pattern
Lately, more and more students are emailing me their current trades. It is interesting to observe the pattern; first they place their trades with real money, and then, when something goes wrong, they email me asking for some insights. I certainly could provide some insight, no doubt about it, yet could the trade be saved by the time I receive their email is the more important issue.

Hesitation always works against an option trader - always. This article will discuss another trade from the reader who asked me for my input early enough in the game. He is certainly open-minded to receive some constructive observations and insights about this trade. Also, he does not mind having me share his trade with the general reading public.


Reader Question
Let us begin, by looking at what he wrote to me:

• "As you can see there is long support that starts from closing price of 12/08/2008. Since now price is around support, I decided to use Bull Put Spread in hope that it will bounce off that support. Also you can see that support line at April exp. date is around 23.5. That’s why I decided to use strike 22.5 to sell. I had two choices for second leg: 20 and 17.5. I was able to get more credit with strike 17.5, so I could use fewer contracts to get same amount of money (less commissions)."

He obviously did a bit of technical analysis first, as he has observed support. After locating the support, he chose from the possible bullish strategies a Bull Put Spread, also known as vertical credit spread. He tweaked the spread in such way that he widened the spread between his sold strike price and his bought strike.

He basically ended up owning the following trade:

STO – 8 Apr 22.50 put

and

BTO + 8 Apr 17.50 put

which gave him the credit of 1.90 per contract; so his Max P (profit) is 1.90 while his Max L (loss) is the spread width or [22.50 put minus 17.50 put] five points minus his Max P equaling 5.00 ? 1.90 = 3.10

The Calculation
In his calculation, he has attempted to come up with two more essential numbers BEP and ROI. For Break Even Point or (BEP), he had 20.60 which is accurate. He sold 22.50 strike price and he received 1.90 in premium per contract. A quick reminder for a Bull Put to be profitable - the price must close above 22.50 and, if it does not, then the only protection which he has is the amount of the premium received which was 1.90; hence 22.50 minus 1.90 gives 20.60 as BEP.

For Return on Investment (ROI) he came up with 163% which I instantly knew was wrong. To calculate ROI we need to divide Max P with Max L (1.9/3.1) which gives us 61%. Evidently, he reversed the numbers.

Thus far, mathematically, he has done well. Nevertheless, option strategy is only a part of option trading - the other more important part isn’t mathematical but psychological. (I shall discuss psychology of option trading in more detail in my subsequent articles.)

Having addressed what he has done correct, let us turn our attention to the things that could have been done better. There are three things we will focus on: 1) Chart, 2) Spread between the Bid and Offer, and 3) Open Interest on individual strike prices.

Chart
Again, I cannot disclose the name of the ticker but we could look at its chart and option chain. For educational purposes we will call this product by a fictional name ZYX.

By the way, while reading this article, be willing to see both sides of the issue and then decide which one resonates better with you. The trade is done by the trader who has never traded options in his life. This is his very first real money trade. May the force be with him, so he could have a good outcome. These are the possible obstacles that I see in this trade:

The first thing I did to evaluate his trade was to pull up the chart. Usually when I am getting a sense for the new underlying, I like to see the weekly chart, if possible five years out. To my surprise the ticker I was given did not even have data for a whole year. In fact, the birth of that product was November 2008.

I quickly checked the same ticker on my second platform just to make sure that there was nothing wrong with the data feed. To my surprise, there was not data error - the product has been in existence less than six months. Regardless of its short life span, it was an optionable product.

Let me attempt to engage you, the reader of this article, by asking a simple question: "How much of the technical analysis could we do on the chart that is in infancy?" Not much. Obviously, we cannot even plot a 200 day moving average, for it has not traded for 200 trading sessions. Besides, we also might have a hard time finding multiple levels of support for that very reason; simply not enough data.

We need to take these things into consideration when we are selecting the product to trade. We need to ask ourselves: Are there some better products out there to choose from? Better ones that have been around for a longer period of time?

Nevertheless, if we stubbornly stick to trading this ZYX product, then we possibly could encounter one of these two possible errors. The two types of errors are: Data Error and Decision Making Error. The first one simply means that the trader, at the moment of entry, did not have sufficient data to make the correct decision.

The latter one is defined as having all the available data present at the time of entry, but the trader has failed to interpret the data accurately. Observe the chart below of Figure 1 and notice the facts which I addressed:


CLICK HERE FOR THE FULL-SIZED CHART


To be continued in Part Two...