Stock Market Spreads
To understand stock market spreads, a trader must first acclimate himself with three popularly and widely used terms. These three terms are a key in mastering the terminology that a successful trader will both use and comprehend. These terms are "bull put," "bear call," and "iron condor." To get a better grasp on what each term means, examine each individually first.
"Bull put" refers to one type of option strategy used when one expects a moderate price rise of the underlying asset. Bull put spreads can be made with in-the-money or out-of-the-money put options, each with the same expiration date (this is also known as a "vertical bull put spread"). This strategy is built by purchasing one put option while simultaneously selling another put option with a higher strike price. The goal of this strategy is achieved when the price of the underlying stays above the higher strike price, causing the short option to expire worthless. This results in the trader being able to keep the premium.
This type of strategy (writing one option and selling another at a higher price at the same time) is also known as a credit spread. It is called a credit spread because the amount received by selling the put option with a higher strike is more than enough to cover the cost to buy the put option with the lower strike. To achieve the maximum possible profit, the strategy must equal the difference between the strike prices and the net credit received. Conversely, a debit spread occurs when the buy put position costs more to buy than the sell put option.
The bull put spread strategy is profitable when the price of the stock moves above its break-even point. The break even point in this case would be the difference between the upper price strike and the net credit.
In summation, in bull put spreads, net credit equals the difference between money received from selling the in-the-money (ITM) put option and the money paid for buying out-of-the-money (OTM) put options. The maximum profit potential equals the net credit received. The maximum loss potential equals the difference between the put option spread and the net credit received.
The second phrase to be familiar with is "bear call." This is a limited profit, limited risk options trading strategy that can be used when the options trader is somewhat bearish on the underlying security. It is entered into by buying call options of a particular strike price and selling the same number of call options of lower strike price (ITM) on the same underlying with same month of expiration.
This type of strategy is used when deterioration in the price of the underlying asset is expected. The maximum profit to be had by the bear call strategy equals the difference between the price paid for the long option and the amount collected on the short option. In other words, if the price of the stock increases above the OTM (or higher) call options and sell ITM (lower) call option strike price on the expiration date, then the investor in question achieves his/her maximum profit potential. Maximum loss would be reached if the price of the stock increases above the OTM (higher) call option strike price at the expiration date. Maximum loss equals the difference between the two strike prices minus the net credit received at the establishment of the spread.
One drawback to the bear call strategy is that even though the level of risk is lower than strictly buying put options, the profit potential is limited. Break-even equals the level at which the lower strike price plus the net credit meet. Another drawback is the idea that maximum profit potential is only if the stock decreases below the ITM (lower) call option strike price.
Finally, let's look at the term "iron condor." The iron condor is one term in a family of terms that each have the name of a flying animal (e.g. condor and butterfly). This term refers to an advanced options strategy which involves the buying and holding of four different options with different strike prices. This is a neutral strategy that is a combination of both the bull put spread and the bear call spread. The iron condor is built by holding a long and short positions in two different strangle strategies. A "strangle" is created by buying or selling a call option and a put option with the same expiration date but different strike prices.
The capability for profit or loss is limited because an offsetting strangle is positioned around the two options that comprise the strangle at the middle strike prices. Therefore, this strategy is mainly used when a trader has a neutral outlook on the movement of the underlying security that the options are derived from.
An iron condor is similar in build to an iron butterfly (four options at three consecutively higher strike prices). The difference is that the two options in the center of the pattern don't have the same strike prices. Having a strangle at the two middle strike prices makes the profit area wider, but also decreases the potential level for profit. However, an iron condor is considered an expensive options trade. This is because of the cost of buying multiple contracts to put on one transaction.
Maximum gain is determined by the net credit received when entering into the trade. Maximum profit is achieved when the underlying stock price at its expiration is between the strikes of the call and put sold. All the options expire worthless at this price.
Maximum loss is significantly higher than maximum profit, but is also limited. Maximum loss occurs when the price of the stock falls at or below the lower strike of the put purchased or rise above or equal to the higher strike of the call purchased. In other words, maximum loss is equal to the difference in strike between the puts (or calls) minus the maximum gain.
Break-even points in this strategy are two-fold. The upper break-even point is reached with the addition of the strike price of the short call to the net premium received. The lower break-even point is determined by the opposite: the subtraction of the net premium received from the strike price of the short put.
To learn more about Credit Spreads and Trade Plans, Check out our blog @ http://www.michaelglass.com
To view video examples of our Trade Plans on YouTube, go to http://www.youtube.com/accendotraders
Tell Me and I'll Forget
Show Me and I'll Remember
Involve Me and I'll Understand
Effective Trade Plans Delivered Daily from AccendoTraders.com
Reuters - International Business Machines has lowered its offer price for Sun Microsystems to $9.50 a share from $9.55 a share, although they are still in talks and the deal is not final, a source with knowledge of the matter said on Saturday.Clickads
Forex Ira Managing
Cool Menu
