After my post on entering into a credit spread on Google in November with December options expiry (see How Stock Options Work: Puts and Calls), some readers asked me to comment along the way and provide an update upon close of the position. Well, as I had anticipated, Google did not close in Dec. below $250 per share, so I got to capture the full spread of close to $800 for 1.5 months of protected downside risk. See this article for full background of the transaction.
Credit spreads are actually quite easy and you can limit your risk as opposed to entering into naked options positions, which is wrought with much higher risk.
If I wanted to duplicate the same type of position today, I could assume that between now and March expiry, Google won't drop another 20% from its current depressed valuation and walk away with another $800 with a maximum downside risk of $5000 if Google dropped all the way to $190 per share, as unlikely as it is:
Sell the March $240 Put for 12.50
Buy the March $190 Put for 4.20
Total Profit = ~$820 net of fees.
Total Risk = $5000 in catastrophic scenario
While volatility has dropped a bit since its peak when I entered into various options-selling strategies, by simply taking on an extra month of expiry and maintaining the same risk, I can roughly mimic the same play time after time.
Note of course, that the market is pricing in some probability that this target price will be reached or else nobody would be buying the option from you. Know your risks before engaging in this type of options play!
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Disclosure: The author is currently long GOOG shares and has no active options positions.
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3 COMMENTS HERE
New to options and I'm not about to try this until I'm completely comfortable with what's going on. I fully understand selling covered calls, but I'm trying to grasp the mechanics of what you did.
I understand that you kept the difference in premium since GOOG stayed above $250, and I understand the worse case scenario in your current example of $5000 maximum risk (excluding exercise fees/commissions).
What I want to understand is the middle area. You sell a $240 put and buy a $190 put. You pocket the spread...ok so far.
Now what happens if the price drops to $210 by expiry? If exercised, you have to buy those 100 shares @ $240, so there goes $24000 out your pocket exluding commissions + exercise fees. The $190 put contract you bought isn't doing you a bit of good. So I'm not seeing how $5000 is your maximum risk.
What am I missing?
Sure, I'd be glad to elaborate. Essentially, rather than getting stuck buying the shares, a bit before expiry (since the option holder on the other end is unlikely to exercise options with meaningful time value still on the option), if Google was at say, $210 as in your example, you could close out the position buy simply buying back the call at (240-210)*100=~$3000 plus whatever time value is left. You could likely sell the put for roughly the same time value remaining, so that time piece might be a wash.
Now, let's say you didn't buy the option back in time and you had it exercised for you and now you just bought 100 shares at 240=$24,000 outflow. However, note that they're worth $21,000. So, again, in this case, as long as you don't hang around and let those shares decline further in value before you sell, the difference is still $3,000.
So, in the end, the real max loss should be $5000 only in the event Google drops below $190.
Now, you can use this same strategy for any stock and it doesn't have to be such a high flyer. For instance, you might pick a $5 spread for say $100 in income. I just chose Google because I know the stock well, had looked at prior resistance levels, etc. and figured that even in this global recession, this stock isn't going to zero.
I see - I completely "forgot" that I'm free to sell those shares after the $240 put is assigned to me and I purchase the shares. Whoops! ;-)
However, that still means that (a) I have to have FCF of $24K lying around or (b) that I'm covered on margin to make the purchase.
And that I want to set up some notification trigger or something that would immediately tell me if I were assigned so I don't just sit there with declining share prices.
Thanks for clearing that one up. For whatever reason, I just kept saying "you're out $24-large if you're assigned; that doesn't make sense!"
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