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Front Spread with Puts

AKA Ratio Vertical Spread

NOTE: This graph assumes the strategy was established for a net credit.

The Setup

  • Sell two puts, strike price A
  • Buy a put, strike price B
  • Generally, the stock will be at or above strike B.

NOTE: All options have the same expiration month.

Who Should Run It

All-Stars only

NOTE: Due to the significant risk if the stock moves sharply downward, this strategy is suited only to the most advanced option traders. If you do not feel comfortable with the maximum potential loss involved with this strategy, consider running a skip strike butterfly with puts.

When to Run It

You’re slightly bearish. You want the stock to go down to strike A and then stop.

The Sweet Spot

You want the stock price exactly at strike A at expiration.



About the Security

Options are contracts which control underlying assets, oftentimes stock. It is possible to buy (own or long) or sell (“write” or short) an option to initiate a position. Options are traded through a broker, like TradeKing, who charges a commission when buying or selling option contracts.

Options: The Basics is a great place to start when learning about options. Before trading options carefully consider your objectives, the risks, transaction costs and fees.

The Strategy

Buying the put gives you the right to sell stock at strike price B. Selling the two puts gives you the obligation to buy stock at strike price A if the options are assigned.

This strategy enables you to purchase a put that is at-the-money or slightly out-of-the-money without paying full price. The goal is to obtain the put with strike B for a credit or a very small debit by selling the two puts with strike A.

Ideally, you want a slight dip in stock price to strike A. But watch out. Although one of the puts you sold is “covered” by the put you buy with strike B, the second put you sold is “uncovered,” exposing you to significant downside risk.

If the stock goes too low, you’ll be in for a world of hurt. So beware of any abnormal moves in stock price and have a stop-loss plan in place.

Maximum Potential Profit

If established for a net debit, potential profit is limited to the difference between strike A and strike B, minus the net debit paid.

If established for a net credit, potential profit is limited to the difference between strike A and strike B, plus the net credit.

Maximum Potential Loss

If established for a net debit:

  • Risk is limited to the net debit paid if the stock price goes up.
  • Risk is substantial but limited to strike A plus the net debit paid if the stock goes to zero.

If established for a net credit:

  • Risk is substantial but limited to strike A minus the net credit if the stock goes to zero.

Break-even at Expiration

If established for a net debit, there are two break-even points:

  • Strike B minus the net debit paid to establish the position.
  • Strike A minus the maximum profit potential.

If established for a net credit, there is only one break-even point:

  • Strike A minus the maximum profit potential.

TradeKing Margin Requirements

Margin requirement is the requirement for the uncovered short put portion of the front spread.

NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.

After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.

As Time Goes By

For this strategy, time decay is your friend. It’s eroding the value of the option you purchased (bad). However, that will be outweighed by the decrease in value of the two options you sold (good).

Implied Volatility

After the strategy is established, in general you want implied volatility to go down. That’s because it will decrease the value of the two options you sold more than the single option you bought.

The closer the stock price is to strike A, the more you want implied volatility to decrease for two reasons. First, it will decrease the value of the near-the-money options you sold at strike A more than the in-the-money option you bought at strike B. Second, it suggests a decreased probability of a wide price swing, whereas you want the stock price to remain stable at or around strike A.

Options Guy's Tips

  • Some investors may wish to run this strategy using index options rather than options on individual stocks. That’s because historically, indexes have not been as volatile as individual stocks. Fluctuations in an index’s component stock prices tend to cancel one another out, lessening the volatility of the index as a whole.
  • The maximum value of a front spread is usually achieved when it’s close to expiration. You may wish to consider running this strategy shorter-term; e.g., 30-45 days from expiration.


Tools

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