Lessons from the Pros

Bull Put, Right or Wrong?

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.

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

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.

1.) 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.

Figure 1

On the chart above, the yellow oval marks the date (12-08-2008) the trader has mentioned in his email and it is off that area that he has drawn the (purple) support line. Again, I will use the exact words from his email: price is around support.

Our teaching at Online Trading Academy is that we enter our Bullish position AT the support. I capitalized the pronoun AT for a reason. The student talks price is AROUND (the) support; those two pronouns are completely different. Observe on the chart that the entry was done when YZX was trading BELOW the support. At that moment the support is broken, it no longer acts as a support. Usually, the old support becomes a new resistance.

Also, the blue oval marks the entry into his spread trade and as you can see at the time of writing this article, ZYX has closed at 19.20 while he has sold 22.50 which means that he is already off by 3.3 points. Moreover, I will disclose just a bit more info about the ZYX; it is an inverse ETF which has a completely different algorithm than ordinary product, and to make things even worse – times three. Not the best place to start as a novice option trader, yet that is exactly what those hotel seminar companies are teaching.

2.) Open Interest

Figure 2 shows both Open Interest and Bid and Ask, so let us start by focusing our eyes on the left side of the option chain where the puts are and look at the open interest specifying that 17.50 puts have only 326 contracts of open interest, while 22.50 puts have "amazingly huge" O.I. of four hundred fifteen. Joking aside, this is pathetic.

Figure 2

Now let us turn our attention to the width of spread between the Bid and Offer. Observe that 22.50 (two levels deep ITM, in the money) puts are trading 6.80 Bid and 7.00 Ask, while 17.50 OTM (out of money) puts are trading 3.50 Bid and 3.60 Ask. Hence 22.50 put has the width of 30 cents, while 17.50 put has 10 cents. By looking at these numbers in isolation, my point cannot be made as easily so I have included Figure 3.

Figure 3

3.) Width of spread between the Bid and Offer

I carefully selected the comparable product to point out that OTM put options are having only 6 cents wide spread between the Bid and Ask (April 43 put Bid 2.12 and Ask 2.18) while two level deep ITM put options have the spread of only 15 cents (April 45 put Bid 3.15 and Ask 3.30). Lastly, Figure 4 points out the difference between the two compared products visually.

Finally, if the student were ready to close his position at the time of writing this article, he would lose money, for he would have to buy back his April 22.50 put for the asking price of 7.00 while the other leg, April 17.50 put, he would sell at the bid 3.50. The difference of the two (7-3.5) would cost 3.50. In retrospect, observe that his maximum loss, if held until the expiry would be 3.10, closing his position right now would produce the additional loss of 0.40 cents per contract share. Not a very good outcome for the very first option trade. Bitterness of the very first option trade leaves the residue for a long time.

In conclusion, the spread between the Bid and Ask is too wide, there is low Open Interest on the individual option strike prices, and the product has not traded for a decent period of time. All of these three points are the reasons that need to be taken into consideration prior to making a trading decision. In this trade, there was a clear Decision Making Error made at the entry. However, the trade could still work out all right.

- Josip Causic