Putting on a Different Kind of Option Contract

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So far, our focus and example trades have involved call contracts. I’ve displayed my preference for vertical spreads over naked options, and the spreads we’ve looked at have been credit spreads, which I also prefer. Other traders have different approaches and have demonstrated success with them.

Today, we are going to look at puts, which I think of as the flip side of call options. A call is a contract that specifies a buying price for an issue. Puts specify a selling price. Out of the money naked puts are seen as a bearish. They make a profit if the price of the underlying decreases. Stockholders may buy naked puts as insurance because they limit the loss on their holdings should their price descend the strike price of the put.

OTM put spreads, on the other hand, can be a bullish strategy. This morning I opened a bull put spread on Pure Package Storage (PSTG). A bull put spread is a credit spread that involves selling an OTM put while a further OTM put is bought. The spread I chose was to sell three September 16 puts at a strike of 28, while buying three puts at the 25 strike. The width of this vertical spread is three dollars. I received a favorable fill that brought me a $1.25 credit for each of the 300 shares in the contract. This trade consumed $900 of my buying power and cost $1.95 total in fees. The credit received is the max profit for the trade. The max loss is calculated by subtracting the credit from the difference between the two strikes ($3.00). So, the max risk is $1.75 per share. If the trade were to go well and expire OTM, the total profit before fees would be $375. Max loss at expiration would be $525. Here’s the profile for the trade when it opened at 0931 this morning:

The two vertical lines mark the breakeven point of the trade ($26.74), and the price of PTSG when we opened the trade ($29.75). After opening, the price of PTSG began to fall rapidly, as did the market in general. I decided to preserve what profit I could by closing the trade just 47 minutes after opening. Closing trades on the same day they open can have negative consequences for trading accounts with a balance of less than $25,000, so if you trade with a smaller account, make sure you understand the day trader pattern rules, which we’ll discuss in a later post. Nevertheless, I was able to buy back my vertical spreads at $95 per contract. The net gain per contract was $30, total gain for three contracts was $90. Total fees for opening and closing the contracts were $3.90, leaving a net gain of $86.10. The return on capital was around 9.5% for a trade that lasted than an hour.

We’ll discuss more about this trade in forthcoming posts.