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This is the fifth week that we have been discussing the bull put spread strategy. We have been following a mock trade using GMCR to show how the strategy works in the real world. This particular trade has gone according to plan, though there still is 18 days left until February expiration.

GMCR announced earnings this past week, which helped push the stock higher and put our bull put trade into a profitable position. The fact that IV fell after the announcement has also benefited the trade. In review, a bull put spread is the simultaneous entry of a short put and a lower strike long put. The long put is purchase for protection so that our risk is limited and so margin requirements won't be so high. The general idea is to find a stock that we feel will find support at a given level so that we can sell a put at or near this resistance level to bring in a credit. If the stock does indeed close above this strike price at expiration, we don't need to do anything as the credit will remain in our account and the options will expire worthless.

We entered this mock trade on Jan. 11 with the week to week data found below:

Jan. 11, 2010
GMCR @ $81.43
Buy Feb. 75 Put @ 3.10
Sell Feb. 80 Put @ 5.00
Max Profit = Net Credit of $1.90 or $190 per spread
Max Risk = $310
Breakeven = $78.10

Jan. 18, 2010
GMCR @ $80.41
Long Feb. 75 Put @ 3.02 (IV-55.6)
Sell Feb. 80 Put @ 5.05 (IV- 53.5)
Max Profit = Net Credit of $1.90 or $190 per spread
Max Risk = $310
Breakeven = $78.10
Current Profit/Loss = ($12.00)

Jan. 25, 2010
GMCR @ $79.98
Long Feb. 75 Put @ 3.45 (IV-69.5)
Short Feb. 80 Put @ 5.65 (IV-68.0)
Max Profit = Net Credit of $1.90 or $190 per spread
Max Risk = $310
Breakeven = $78.10
Current Profit/Loss = ($30.00)

Feb. 1, 2010
GMCR @ $84.41
Long Feb. 75 Put @ 0.47 (IV-45.4)
Short Feb. 80 Put @ 1.33 (IV-42.0)
Max Profit = Net Credit of $1.90 or $190 per spread
Max Risk = $310
Breakeven = $78.10
Current Profit/Loss = $104.00

Figure 1: Platinum Data and Risk Graph

Notice how IV has come off sharply from its level near 70 in the prior week. The drop from 68.0 percent to 42.0 percent in IV for the short option is a 38 percent drop. This decline in IV has added to our profits. Look how the value of the trade would change if IV remained at its levels from a week ago:

Feb 75 Put @ 45.4 percent = 0.47
Feb 75 Put @ 69.5 percent = 1.55
Difference in value = 1.08

Feb 80 Put @ 42.0 percent = 1.33
Feb 80 Put @ 68.0 percent = 3.03
Difference in value = 1.70
Net change is 62-cents or $62 per spread

Therefore, if IV were at the same level it was a week ago, our trade would be worth $62 less than it is at the moment. However, this doesn't matter at all if we hold onto the options until expiration. At expiration, IV is nonexistent, so it only matters where the stock sits compared with the strike price.

Looking at the probability of profit and expected profit for this trade, we see the odds are squarely in our favor:

Figure 2: Screenshot of Probability Data in Platinum Pro

This tool provides information about the statistical odds of success and expected profit. This is based on the statistical volatility of the stock. In this case, the program is using the 100-day SV, which sits at 44.56. If the 6-day SV were used, it would lower the odds of success since SV is in the 60's the past 6 days. This data isn't usually used for anything other than a gauge. In essence, the current screen shows that the odds of success and expected profit are very high.

When looking at an exit strategy, the trader must decide whether he or she wants to hold on to the trade for the next 18 days to possibly receive the max profit, or if it would be better to get out with a given profit and move the capital to another trade. In general, many traders will get out of a trade like this if the available profit is at least 80 percent of the max profit. In the case of our trade on GMCR, this would mean exiting the trade when we can get a profit of $152. If the stock remains near $84 and IV remains where it is currently, this would create an exit point with about 6 days until expiration. Of course, if IV falls further and/or the stock rises, this exit point could come sooner. However, if the stock falls back toward support at $80, the ability to get at least 80 percent of the max profit might not occur until the week of expiration, possibly even a day before.

Jody Osborne
Senior Writer & Options Strategist
Optionetics.com ~ Your Options Education Site

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