Blog

And Now an Index to Track Trump Tweets, welcome ‘Volfefe’ index

JPMorgan has created a ‘Volfefe Index’ to track how President Trump’s tweets affect financial markets.

With over 64million followers, President Trump is widely known for his tweets. And since he started asking Fed to lower rates, those tweetstorms have actually started to impact financial markets. In fact, since trade war with China intensified, more and more traders around the world have started to take note.

What is “Volfefe”? What does it mean?

Remember “Covfefe”? The mysterious tweet from Mr Trump in 2017 that left his millions of follower baffled and it became one of the most talked about tweets. Since that May 2017 “Covfefe” tweet, Mr Trump’ followers have now doubled over 64millions from 30+ millions!

Analysts at JPMorgan Chase & Co. have created an index to quantify what they say are the growing effects on U.S. bond yields.

As per a report published on Bloomberg:

JPMorgan’s “Volfefe Index,” named after Trump’s mysterious covfefe tweet from May 2017, suggests that the president’s electronic musings are having a statistically significant impact on Treasury yields. The number of market-moving Trump tweets has ballooned in the past month, with those including words such as “China,” “billion,” “products,” “Democrats” and “great” most likely to affect prices, the analysts found…

JPMorgan’s analysis looked at Treasury yields in the five minutes after a Trump tweet, and the index shows the rolling one-month probability that each missive is market-moving…

They found that the Volfefe Index can account for a “measurable fraction” of moves in implied volatility, seen in interest rate derivatives known as swaptions. That’s particularly apparent at the shorter end of the curve, with two- and five-year rates more impacted than 10-year securities.

More and more analysts are following and analysing Trump Tweets. If you don’t know it already, Bloomberg also has a tracker to track Mr Trump’s tweets.

Analysts at Bank of America Merrill Lynch concluded that days during which Trump tweets relatively frequently tend to see negative stock returns of 9 basis points on average. Days with fewer presidential tweets tend to see positive returns of 5 basis points on average.

As of now, I haven’t found a way to use “volfefe index” for real money trading. I will update you once I find something meaningful. In the meanwhile, if you find something interesting, please add to the comments section. I will be glad to research more and share my thoughts.

Profitable trading, OP

September 9, 2019
Why Should You Paper Trade Options
[vc_row type=”in_container” full_screen_row_position=”middle” scene_position=”center” text_color=”dark” text_align=”left” overlay_strength=”0.3″ shape_divider_position=”bottom”][vc_column enable_animation=”true” animation=”none” column_padding=”no-extra-padding” column_padding_position=”all” background_color_opacity=”1″ background_hover_color_opacity=”1″ column_shadow=”none” column_border_radius=”none” width=”1/1″ tablet_text_alignment=”default” phone_text_alignment=”default” column_border_width=”none” column_border_style=”solid”][vc_column_text css_animation=”none”]

“Will you skydive without knowing how to operate your parachute?”

Investing and Flying are similar, in some ways.

Many new traders doubt if Paper Trading is still relevant? does it do any good at all. They claim that it is a different “feel” when your actual hard earned money is at risk.

“Your emotions are your biggest baggage when it comes to trading and investing and so you need to go through the “real-pain or gain” to know “how it feels like” to be a trader”…many think that way…

There’s no denying on “feeling part”; albeit, emotions is just one aspect and in my opinion, it is not very important while you are beginning to learn trading. It’s importance, however, grows over time.

So why should you pay attention to paper trading? why is it still relevant and will continue to be relevant?

I trade on paper money even now…why?

Let’s categories the reasons into four broad categories:

To Know The Trading Platform

If you think education is exepnsive, try ignorance. – Derek Bok

When you want to drive a car, you need to understand your car’s operations. You need to know how to start, stop, drive, turn, reverse, park etc., and the list goes on and on. Similarly, in order to execute your trades, you need a trading platform which is usually provided for free by your broker who opens your account and allows you to trade.

And guess what, you might have wonderful ideas, trading systems and strategies, but you can only execute those if you understand the trading platform.

So what are some of things you need to learn before you could place your first REAL-MONEY trade?
1. You need to understand your account information which includes deposits, withdrawals, current balances and so on.
2. You need to learn how to analyze, open, monitor and close positions for your desired trading srtategy and system.
3. Trade identification is one of the first areas you will have to spend time on so knowing how to find, filter and identify trades on your trading platform will be extremely useful.
4. And if you are like most traders, you would want to watch market action and create watchlists, stock filters , etc. for keeping an eye on potential future opportunities.
This is just the beginning.

As you can see, you don’t wanna experiment all this with real-money.

By Paper trading or simulating real-trading environment on a virtual trading account, a newbie trader can avoid painful mistakes that are often triggered due to trading platform ignorance.

To Understand Options Better

Options are different. Different from stocks, forex and other financial instruments that you might’ve been familiar with.

In order to avoid single biggest mistake that new traders commit when they start trading options, I suggest that you may want to read TOP 10 things about options. This will provide you with a primer on what is an option, call option, put option, option buying, option selling and some other characteristics of options such as expiration date etc.

Trading options usually involves more steps then simply buying and selling shares. The option price also changes differently to different market conditions. Paper trading first will help you understand how options are different from other instruments.

To Manage Yourself Better

Prove you can follow the process first, commit capital later.

Just like any other other business, Trading business also involves a process. And process is best summarized via your, lets call it, standard operating procedure (SOP) that lists who you will find, filter, enter, manage and exit a trade.

Before you commit to real money capital, you need to show, prove to yourself that you can actually follow your own trading systems and strategies. Notice, I didn’t say Profit & Loss; for a new trader learning and mastering the whole process is more important.

Do you do proper preparations? do you have patience, persistence and perseverance to follow through your complete trade’s process?

Paper trading thus becomes an invaluble tool so you could check your discipline and adherence to your trading plans. The more you practice your trading process on paper money, the more painful mistakes you will avoid in future.

That leads me to emotional aspect of the trading process.

There are two very powerful human emotions that can affect the outcome of your trading results massively. Fear and Greed.

“Trading without emotions requires 3 things. Practice. Practice. Practice.”

Let’s go through a recent example:

US Markets have been running a wild rally for a long time. Going up and up and turning into a parabolic rally in Dec’17 to Jan’18.

Look at the chart below; while witnessing a parabolic rally compared to the mild rally over the last year, one should unemotionally start reducing long positions, even though the crazy rally could have made you more money had you kept your long positions for just a little longer.

Experience makes you appreciate that although in a bull market the probability of continuing the trend is greater than stopping for a correction / consolidation / ugly crash, it doesn’t mean that the unlikely will not happen — unlikely is not equivalent to impossible.

Thus, veteran traders would have begun to reduce their long exposure.

It is the experience and the appreciation of risk that empowers these traders to survive and become veterans.

This is what happened next. The Dow Jones Industrials Index dropped over 2500 points in a matter of days, wiping out the whole parabolic rally and some more!

Though Dow Jones has recovered much from it, the deep dive has wiped out many traders with emotional bias such as “This is just a pull back”, “I shall not quit at the darkest hour before dawn” — Market remained irrational just for a few days, before they could remain solvent.

Let’s take PP33 (a powerful strategy taught in OptionPundit’s ProfitPath Intensive Program) as another example.

Not every time the stock breaks through the threshold level smoothly, does it? Therefore, experience here comes to aid as it keeps you calm and patient when the stock makes a false breakout or dancing around the threshold levels.

Experience means a large number of trials, a big sample, statistically sound prediction.

Thus you could sit calmly when the stock is going sideways or going against you — you understand such cases are bound to happen, and they are not the ones (that make you money)! So you will and give them up and give yourself a break, rather than feeling a little frustrated having to cut loss short on the false breakout.

How to get the large amount of experience without financial ruins? You know it now.

With paper money, you will gradually stop thinking profits and losses as tangible stuff such as an iPhone, a camera, a month’s rent or salary. When you stop thinking money as stuff but multiples of risks involved, you are closer to emotionless trading.

Examples:
- I risked 1R (100% of risk parameter, which could be 5% of account size) and made 3R.
- I risked 2R and cut loss at 1.7R, etc.
Since it is not real money, you:
- stop wanting home runs in one trade because the fake profits don’t get you better houses or cars.
- feel OK to obey the rules for capital allocations
- feel OK to cut loss and cut loss short.
Before you know it, these practices become habits and then become you. The idea of “show hands”, “be tough and hold on” stop occurring to you. Then your trades look like these, managed losses and occasional great wins…

With enough practice, You become extremely impatient with losing trades but very patient with winning trades.

Wouldn’t you like this? — I hope someone told me these words when I began trading!

To Develop A Trading Edge

Now, lets move one of the key reasons I still paper trade.

Market dynamics change, and so do the market internals. Being an options trader, my trades are structured and designed as per my biases around Delta, Gamma, Theta or Vega.

Whenever I have an untested trade idea or hypothesis, especially one whose risk is undefined or unclear to me, I trade those on paper money. I develop my hypothesis, trade plan, key points to watch out during the life of the trade. I develop comprehensive trading system summary and my scorecard for that new trading hypothesis.

Then I trade that hypothesis. Trade develops through various market moves. I take note and revise my hypothesis, if need be.

I do that again.

Then I repeat the process, all over again. I do it many times before I start testing it with small amounts of real money…and again…before committing large capital to it.

Paper trading or simulating your trades is essential for your long term success in trading. There is no short cut. It can save you from potential emotional disasters and/or financial ruins.

Did you paper trade before diving into real-money trading? What did you learn during paper-trading? Was it worthwhile to paper trade? What will you suggest to a new trader?

[/vc_column_text][/vc_column][/vc_row]
July 12, 2018
US Presidential Elections- How Will Stocks React?

Do presidential elections affect US stock market? How will stocks react to Mr Trump’s or Mrs Clinton’s win?

The End Of Presidential Second Terms (8 year cycle)

Based on historical data, it may not be smooth sailing for the stock market this year. Since 1900, On average, The S&P 500 has dropped an about 1.2 percent in 4th year of second presidential terms. 2008 was specially notorious, when market pulled back approximately 40%, and it also happened to be Mr Bush’s last year of his 2nd term in the office.

2008 was a year you probably you don’t want to remember; a year when many people were re-structured, unemployment was surging and the housing crisis was its peak. Even the serious, professional investors were suffering from the stock market collapse.

It is also worth noting that even though the S&P 500 was down an average of 1.2 percent during year eight of the presidential terms since 1900, it experienced positive growth in some years. Forty-four percent of the years in that period saw a rise in the S&P 500. Although that data point doesn’t convince some analysts this year could see gains in the market, it may offer some investors a glimmer of hope for a recovery from recent declines before the year is over.

Road Ahead: Known Unknowns or Unknown Unknowns

As widely know, Presidents can be a bit unpredictable during their final year of a second term as they come to face their limited time left in office. Unpredictable behavior combined with a lack of consensus of who the next president will be can fuel a lot of uncertainty that can upset the stock market.

Jeff Hirsch, editor in chief of the Stock Trader’s Almanac, describes exiting commander-in-chiefs as “lame duck presidents with little political capital left,” who as a result “push through policy initiatives by executive orders and any other means possible.”

Hirsh also said, “The eighth years of an incumbent’s term in the White House have all been pretty horrible for markets with the exception of 1988 when Ronald Reagan was leaving office. And the first five months of an election year are generally very telling. If you’ve got a down year, that’s usually indicative of the incumbent White House party being ousted. That clearly puts a dampener on Mrs Clinton’s prospects. As they say, the stock market is like a voting mechanism.

Through the lense: A 4 year presidential cycle

As per historical data, The fourth year of a president’s first term tends to fare much better. Some associate the general trend of incumbents getting reelected as a reason why there is less panic in the stock market during those years as compared to year eight. Since 1900, 83 percent of the time year four of a president’s first term has seen an average gain in the S&P 500 of 11.5 percent.

Pre-election years have performed the strongest when looking at four-year cycles, which clearly stand out in the below chart.

Here is visual, simple yet powerful chart describing market action during various phases of election cycle. (h/t : SeasonCharts.com)

Party Impact

Yes, parties to impact the outcomme for the stock market. Which party is likely to be voted into office during an election year can also affect how stocks perform, especially as the election date approaches. Typically when people believe the incumbent party will get elected, the market goes up. If consensus points towards a new party taking over, however, the stock market tends to go down. Uncertainty and fear can cause increases in volatility compared to feelings of confidence and the familiar.

There can be inductry specific impact based on which party the new president is from. For example, pharmaceutical companies could experience gains with a Republican taking over since many Democrats want to cap drug pricing. FYI, just recently Eli Lilly (LLY) stock price pulled back sharply when Mr Sanders tweeted about the cost of Humalog insulin.

Coal is another industry that might rebound with a Republican in office since they typically are not as strict with air-quality regulations and the industry experienced close to an 80 percent decline in 2015. There are many notable plays that are waiting for some breathing space.

Role of November and Post-Election

First, lets go back to 1960 to view Nov only data, we find that there is a bias for the month to end positively 61% of the time. In other words, 3 out of every 5 months finished in positive territory, which is why it is included in the seasonally strong period of the entire year. Furthermore, the average and median returns for the month top 1% over the course of that time.

However, when we look at just the November months when elections are being held, we find 50/50, well almost, split of wins and losses. Even though the number of months are evenly split between gains and losses, the average and median returns were still positive over the given time frame.

Unfortunately, average and median returns aren’t representative of the capital loss hat have taken place historically, such as the massive drawdown during the 2008 election. Importantly, in order for the market to have an average return of 1.01%, it means there has been a variability of returns both above and below that average.

However, during election years, we see the same periods remaining weak, but more dramatically so, as the volatility of election years skews the average of all years. In other words, regardless of who is elected on the 8th, look for a relief rally on the 9th, followed by a sell-off over the next few days? The traditional post-Thanksgiving rally tends to be stronger performance-wise during exceptionally light volume trading days.

How can you profit/protect your portfolio?

One way is that you trade directionally, do a through analysis, find out the appropriate sectors/companies that will benefit from most likely candidate’s winning. However, with so many uncertainties lying ahead, one thing seems sure; the probability favors for volatility of the overall market to rise until the time the results of the elections are out in Jan 2017. Also don’t forget that we are within 5-7% range of all time high.

Using volatility as the main instrument, the best strategy might be LONG VEGA strategies or simply buy those products which benefit from positive Vega like long VIX Calls or long shares of VXX.

I am of the opinion to sell 90% probOTM VXX puts until results are clear.

Selling Put options is a bullish strategy. Thus by selling put, essentially, it is long volatility trade. However, by compbining with high probability factor, it gives us higher chance of being profitable, even if we are wrong.

(Disclaimer- This trade idea is intended for education and entertainment purpose only. You should talk to your investment adviser and do due diligence before taking any action based on what’s written below).

If you are looking for a quick, easy-to-understand, simpe primer/intro on options, here is our most popular ebook. You might want to download as long as we are distributing it for FREE.

Let me know what do you think? or should you have another idea that you would like to implement for trading the markets during this cycle.

Profitable Trading, OP

(Disclaimer: This post provides you with key observations, collected from various well documented sources such as Yahoo Finance, Motif investing, Seasonal Cycles, etc. I have added few additional thought on how can you use these conclusions to trade markets in the near short-term.)

November 3, 2016
After this, Is Apple Inc About to Fall From the Tree?

On April 26 after market close, Apple Inc. (NASDAQ:AAPL) reported earnings for its second fiscal quarter and issued guidance for its third fiscal quarter. Apple posted its first-ever decline in iPhone sales and its first revenue drop in 13 years!!

Earnings of $1.90 per share fell short of the average analyst estimate of $2 per share, according to Thomson Reuters I/B/E/S. Revenue of $50.56 billion missed expectations of $51.97 billions. Its shares fell a whopping 8 percent, wiping out almost 45billions from market cap. As if these poor results weren’t already bad enough, the company announced poor guidance for the third quarter. Revenue is now expected to be in the range of just $41 billion to $43 billion, widely missing a consensus of $47.32 billion!!

Wow. Take a minute to digest what just happened!

The most popular stock market darling, the biggest company on planet earth just missed expectations, declines in earnings/revenue and outlook negative first time in 13 years and that’s happening right after “not-so-bright” results from Microsoft (MSFT) and Alphabet (GOOG).

Is Time Over for Apple Now?

Of course, as one would Expect, Mr Tim Cook said “The future of Apple is very bright” and that “Our product pipeline has amazing innovations in store.”

The investors don’t seem to be so excited in spite of raising its capital return program by $50 billion through a $35 billion increase in its share buyback authorization and a 10 percent rise in the quarterly dividend

It Pays to Prepare in Advance

I hope you learnt the power of options beforehand so you could have protected your portfolios before earnings announcement (if not, join here). In fact, few years ago we detailed a comprehensive post outlining 3 options strategies that one could use to protect their shares (Click here to learn from this educational post)

Some Ideas on What do now?

When stock opens for trading tomorrow, there will be two camps of traders. One who thinks it is a great opportunity to be a buyer and another who thinks that apple will crash to new lows. Whatever it is, here are my three cents-

As Apple results make headline tomorrow onwards, don’t jump to early conclusions as if all is lost. Unless $90+/- is taken out, I will stay positive about the company and wait for the next trigger. Apple has clear support around $90+/- and during post earnings announcements, it dropped to $96. If Apple shares were to drop further, and break $89 (which I assume will be a popular stopout area), you might want to protect your apple holdings.

Do your homework before market opens so you have strategies and system in place. If you would like to have my opinion on your ideas, post your views/trade ideas in the comments section. I will be glad to share my views.

Good luck.

Do You Need Our Help

If you happen to be flying into Singapore on 14th May, Come over and join for a FULL-Day training on Options, FREE of cost. In fact, we’ll host you for tea and coffee too. We’ll reveal powerful strategies that are working in current market environment– and at the same time teach you how to protect your portfolios too.

Click here to join the event, only if you are in Singapore on 14th May. We only have 49 seats now!

Profitable Trading, OP

April 27, 2016
This is how you trade Market Uncertainty
Valeant Pharmaceuticals Intl Inc (VRX) dropped over 50% on Tuesday trigerring billions in losses for Hedge funds including the famed investor Mr Bill Ackman of Pershing Square. Is there a way you could have profited while big funds lost billions? Straddle spread is one such strategy that can be used in such instances.

It was a public information that VRX will be announcing ernings before Market opens on 15 Mar 2016. The results are usually 50/50 i.e. we don’t know whether the stock will go up or down after earning announcements. And it is this type of uncertain situation which makes it difficult to structure a pure directional trade. A straddle spread is market neutral trade and thus it benefits from either direction move.

STRADDLE SPREAD

Straddle is an option trading strategy which involves buying or selling both call option and put option simultaneously. Both call and put options we purchase (or sold) have to be of the same underlying stock, and same expiration date. Both options will be bought/ sold at-the-money (ATM) strike. (Strike that is nearest to Current stock price).

Let’s use an example to understand how a long trade could have been placed. Just before the market close, the options were pricing a $9+/- move post earning announcement and VRX closed at $69.04 on 14 Mar 2016.

Here is how to structure a straddle spread:
- Nearest Strike – $69
- Expiration – Mar 2016 Monthly (expiring in just 3 days)
- Buy One Call Option : $4.55
- and Buy Equal Amount of Put Option: Cost $4.45
- The net debit for Straddle Spread is $9 (or $900 as 1 option controls 100 shares)
- The breakeven are – $60 and $78
Let’s see how this look like on a stock price chart-

Let’s talk about various “What-if” scenarios-

Scenario 1: Assume that the Stock is trading at $80 at expiration date.
In this case the trade is going to be nicely profitable. The Put Option will be worthless while the Call Option will be worth $11 ($80-$69=$11), thus netting a +22.2% gains (excluding commissions).

Scenario 2: Stock is trading at $58 at expiration date.
In this case, the Put Option will be worth $11 ($69-$58=$11) and the Call Option will be worthless. Thus the gains are going to be similar as in the first case i.e. +22.2% gains.

Scenario 3: Stock is trading at $69 at expiration date.
This is the absolute worst case scenario that assumes stock staying at $69 after earning announcement. In this case I would incur maximum loss, which is the actual size of the initial debit I paid for the purchase of options. Maximum loss is therefore $900.

Let’s also note that 52wk, High/Low range for VRX is $263.8-$59.8.

Just as with any other strategy, there is risk of loss of entire capital in case VRX doesn’t move at all (scenraio #3). However, based on past 12 median earning moves, VRX does move about 4-5% (thus about $3+/-) thus we might lose about 50% if the move is in accordance to the past.

The stock has been very volatile recently and it moved from $250+/- to $70+/- in the last 6 months alone, thus making it high risk/high reward play on every earning announcement recently.

WHAT ACTUALLY HAPPENED

VRX dropped almost $35.5 (or 50%) to close at $33.51!!! The value of the spread soared to almost $35!! Resulting into +288% gains in a single day.

LEARNING & WATCH OUT

Should you use this strategy for all the companies that are going to announce earnings? Absolutely not.

The options premium is very high before earnings announcement and soon after the announce those premium will crash due to implied volatility drop. Proper preparation and planning is required to understand implied move in the current options prices, how much has it moved during the past, say 8, quarters and what’s the level of curent uncertainty.

Once you understand the risk, allocate money diligently and understand the risks completely, straddle spread can be a good non-direction spread to profit from uncertainty.

Your Turn

What do you think of this strategy? What issues do you see? How can you make it work for you? Can you propose or define a criteria so that it could become a consistent strategy?

Profitable Trading, OP
March 16, 2016
Bear Vertical Spread Explained
What is a Vertical Spread? We explained this at great length in the previous article using an example of Bullish Vertical Spread. We explained all the basics of vertical spread, how to structure it, how to analyze its risk reward profile and how to interpret profit & loss of a bullish vertical spread. This article is now focused to explain what is Bear Vertical Spread.

Before analyzing bearish trading strategy using verticals, let’s review what is a Vertical Spreads strategy:
- Vertical spread is an option spread trading strategy in which trader purchases a certain number of options and simultaneously sells an equal number of options. Both sold and purchased options have to be the same class (i.e. Call or Put), same underlying security, same expiration date, but at different strike prices.
- Since purchased and sold options are of the same class (either puts or calls), a trader’s positions are hedged against each other – while one option is making money the other option is losing money.
- By setting up (structuring) options in this manner, trader limits the risk involved, but at the same time trader limits the profit potential too.
Vertical Spreads can be either Debit Spread or Credit Spread, and can be created with either all Call Options or all Put Options and can be created for Bullish or Bearish directional view.

What is a Bear Vertical Spread?

Bear vertical spread is an options trading strategy designed to profit from a decline in prices. It is constructed by purchasing a certain number of options and simultaneously selling an equal number of options. Both sold and purchased options have to be the same class (i.e. Call or Put), same underlying security, same expiration date, but at different strike prices.

It can be structured (set up) in two ways:
- By using Put Options – “Bear Put Spread” – also called a Put Debit Spread.
- By using call options – “Bear Call Spread” – also called a Call Credit Spread.
When constructed with similar strike prices and similar expiration dates, both Bear Put Spread and Bear Call Spread have almost the same risk/reward profile, as we will show in our chart/graph example. A Trader may choose either of the two vertical spreads for trading his directional view. However, it is much better to structure a trade based on:
- Bid/Ask slippage
- Ease of fill
Generally speaking, it is better to structure a trade using “out of the money” options as it will be easier to fill.

Using a hypothetical example of a stock, which is trading at $50 at the moment, we will now review Bear Put Spread and possible outcomes (profit/loss). Let’s assume-
- We are bearish on this stock, for whatever technical or fundamental reason, and we assume it will decline in price moderately by the end of this month.
- Let’s suppose our bearish signal occurred today (Jan 18^th for example) and Bear Put Spread is the strategy of our choice. Important note is the expiration date of our Put Options, which is Jan 31^st.
- On Jan 18^th we decided to go with our strategy, having in mind the expiration date is Jan 31^st.
- Stock is currently trading at $50.00 per share.
How to Set-up Bear Vertical Spread Using Put Options?

Here is the price chart marked with entries for structureing bear spread using Put Option:

How to Structure A Bear Put Spread?
- As shown in the chart, first we will buy 1 Put Option with a strike price at $48.00, which is trading at $0.40 per share (for example) – since 1 options controls 100 shares, we will spend $40 for this put ($0.40 x 100 = $40).
- At the same time, we will sell 1 Put Option with a lower strike price of $46.00, which is trading for $0.10 per share – for this sale we would receive $10 ($0.10 x 100 = $10).
- By setting up two options in this manner, we have constructed (purchased) a Bear Put Spread which costs us $30. We spent $40 for buying the $48.00 strike put, while we received $10 for selling the $46.00 strike put ($40 – $10 = $30).
Since it costs us to open this spread, it is called a Debit Spread. In this case, our Initial Debit is $0.30 per spread. ($30/100 = $0.30).

Let’s take a look at the same chart with profit/loss areas when price moves in different directions as the expiration date draws near.

The price at $47.70 represents our breakeven point, and any price move below that value would result in profit.
- Our options (long put and short put) are hedged against each other – the $48.00 strike long put starts to make money as soon as price falls below the $48.00 value. At that time our short put is still “out of the money”, but as soon as price falls below $46.00 value, that short put starts working against us (remember, we sold that put to somebody). Since these options are the same class and in same number, and price may fall significantly lower than $46.00 – it won’t have any effect on our profit. Thus maximum profit will be realised when stock price drops below $46.00.
- Price at $47.70 is our breakeven point, and price movement below that point will lead us to profit (“partial profit”), as shown in the chart. It will do so until $46.00 strike price is reached, which represents our maximum profit price.
- In case price stays above $48.00 value, we will lose only the initial amount we spent for this investment (Bear Put Spread Debit) – $30.
Here is the visual representation of the risk/reward profile at expiration to explain what we just described above:

As you can see, the price can be at any value above $48.00 – it will not affect our loss which is capped at $30 – which is the actual amount of our Debit. Moreover, the price of this stock may even go to $0 – it will not affect our maximum profit which is capped at $170.

[color-box color=” customcolorpicker=” rounded=false dropshadow=false]

Geek’s Notes: Detailed calculations of the Risk/reward

Here are the detailed calculations of our Bear Put Spread, with regard to different stock price scenarios at the expiration date (Jan 31^st).

Scenario 1: Stock is equal to or below $46.00, let’s say at $44.00

In this case we would make maximum gain. Profit would be calculated based on intrinsic values of Put Options at expiration.
- Intrinsic value of purchased Put Option ($48.00 strike), I_p= $48.00 – $44.00 = $4.00.
- Intrinsic value of sold Put Option ($46.00 strike), I_s= $46.00 – $44.00 = $2.00.
Profit/loss = I_p – I_s – Initial Debit = $4.00 – $2.00 – $0.30 = $1.70. Since options come in lots which represent 100 shares, our profit will be $170.00 ($1.70 x 100 = $170.00). Compared to our initial investment (Debit) it is a 566% gain ($170/$30 = 566%).

Scenario 2: Stock is equal to or above $48.00, let’s say at $52.00

In this case we would make maximum loss. Let’s show the exact calculation based on intrinsic values of Put Options at expiration.
- Intrinsic value of purchased Put Option ($48.00 strike), I_p= $48.00 – $52.00 = $0.00 (since it can’t have negative value).
- Intrinsic value of sold Put Option ($46.00 strike), I_s= $46.00 – $52.00 = $0.00 (since it can’t have negative value).
Profit/loss = I_p – I_s – Initial Debit = $0 – $0 – $0.30 = -$30.00 ($0.30 x 100). Our maximum loss in this case is $30 – which is the amount we “spent” for purchasing this Bear Put Spread.

Scenario 3: Stock price is somewhere in between our Put Options, let’s say at $47.00

We will calculate our profit/loss based on intrinsic values of our Put Options at expiration.
- Intrinsic value of purchased Put Option ($48.00 strike), I_p= $48.00 – $47.00 = $1.00.
- Intrinsic value of sold Put Option ($46.00 strike), I_s= $46.00 – $47.00 = $0.00 (since it can’t have negative value).
Profit/loss = I_p – I_s – Initial Debit = $1.00 – $0.00 – $0.30 = $0.70. Since each option controls 100 shares, our gains would be $70.00 ($0.70 x 100). That is 233% gains ($70/$30 = 233%).

[/color-box]

Try now. Use any of the free finance portal e.g. Yahoo Finance, choose an underlying e.g. Apple (Symbol: AAPL), find option prices and construct a Bear Put Spread. Let me know (via comments below) what you did and I will be happy to share my thoughts if you got it right.

How to Set-up Bear Vertical Spread using Call Options?

Now, let us set-up the same trade using Call Options. We shall use same set of assumptions i.e. based on same hypothetical stock example we used when we constructed Bear Vertical Spread with Put Options i.e. stock is trading at $50.00 at the moment, and expiration date is Jan 31^st.

First we will buy 1 Call Option with a strike price of $48.00. Simultaneously, we will sell 1 Call Option with a strike price of $46.00. Let’s assume the credit we received with these combined options is $1.70. Since each option controls 100 shares, we would receive $170 credit.

The goal of this strategy is to benefit from the decline in the stock prices to potentially below $46.00 enabling us to keep the $170 credit premium.

Here is the chart with Bear Call Spread Set-up:
- Our both sold and purchased call options are “in the money” since at the moment of setting up this trade, the stock price is above them.
- The $48.00 strike price Call Option starts working against us as soon as stock price declines to or below the $48.00 strike price. But as stock price declines, the Call Option we sold (strike price $46.00) is working for us the whole time – options are hedged against each other.
- If price declines below $46.00, both options would expire worthless, and we would get to keep the premium we received as our maximum profit, which is $170 ($1.70 x 100 shares).
Let’s show the profit/loss graph which is practically same as with Bear Put Spread, the only difference being in the purchase/sale of the respective calls.

Why buy higher strike and sell lower strike in case of Bear Call Spread?

It is because we are comparing the risk/reward profile with respect to Bear Put Spread and we are using the same strikes. And since we are constructing this trade using Call Options, it will be opposite of Bear Put Spread.

By setting up two options in this manner, we have constructed (or sold) a Bear Call Spread and we collected $170 credit. Since it gave us credit to open this spread, it is called a Credit Spread. In this case our Initial Credit (I_c) is $1.70 (or $1.70 x 100 = $170).

[color-box color=” customcolorpicker=” rounded=false dropshadow=false]

Geek’s Notes: Detailed calculations of the Risk/reward

Detailed calculations of risk/reward are explained below:

Scenario 1: Stock is equal to or below $46.00, let’s say at $42.00

In this case we would make maximum profit which can be calculated with intrinsic values of both calls at expiration date.
- Intrinsic value of purchased Call Option (strike price at $48.00), I_p = $42.00 – $48.00 = $0 (since it can’t have negative value).
- Intrinsic value of sold Call Option (strike price at $46.00), I_s = $42.00 – $46.00 = 0$ (since it can’t have negative value).
Profit/loss = Initial Credit + I_p – I_s = $1.70 + $0 – $0 = $1.70. Since each option controls 100 shares our profit would be $170 ($1.70 x 100). In this case we would get to keep all the credit we collected by opening this kind of spread. We would achieve maximum reward of 566% ($170/$30).

Scenario 2: Stock is equal to or above $50.00, let’s say at $52.00.

In this case would make maximum loss which can be calculated with intrinsic values of our options at the expiration date.
- Intrinsic value of purchased Call Option(strike price at $48.00), I_p = $52.00 – $48.00 = $4.00.
- Intrinsic value of sold Call Option (strike price at $46.00), I_s = $52.00 – $46.00 = $6.00.
Profit/loss = Initial Credit + I_p – I_s = $1.70 + $4.00 – $6.00 = -$0.30. Our loss would be $0.30 per share, and since each option controls 100 shares, our maximum loss would be $30.

Scenario 3: Stock is in between our strike prices, let’s say at $47.00

In this case we would make partial profit – which will again be calculated based on intrinsic values of options at expiration date.
- Intrinsic value of purchased Call Option (strike price at $48.00), I_p = $47.00 – $48.00 = $0 (since it can’t have negative value).
- Intrinsic value of sold Call Option (strike price at $46.00), I_s = $47.00 – $46.00 = $1.00
Profit/loss = Initial Credit + I_p – I_s = $1.70 + $0 – $1.00 = $0.70. Since each option controls 100 shares, our profit would be $70. Reward in this case is 233% ($70/$30).

[/color-box]

As you may notice, in both cases, the profit/loss (risk/reward) was same whether you chose Bear Put Spread or Bear Call Spread using the same strikes. However, as mentioned earlier, it is much better to structure a trade based on bid/ask slippage and ease of fill which, generally speaking, is good for out of the money options.

Bottom line, it will be much better to use Bear Put Spread vs. Bear Call Spread (in this example) as Puts will be much easier to be filled vs. Calls which are deep in the money.

Be Patient with Yourself

In this post I covered BEARISH VERTICAL SPREADS using both put options and call options. In the earlier post, I covered BULLISH VERTICAL SPREAD in a very comprehensive manner. The nature of this strategy is LIMITED RISK, LIMITED PROFIT. Use this spread to trade directionally to minimise your risk.

Finally, I have to remind you to be patient with yourself. This isn’t all going to fall into place tomorrow. My goal is to give you a roadmap and a bunch of examples, so you see where you want to go with your options trading and have the skills to get there day by day.

How do you like it? What additional thoughts or questions do you have? I will answer every question, no strings attached. Make sure to leave your comments or questions so you can make the most of your learning.
February 24, 2016