The latest correction in stocks has caught a lot of investors off guard. When holding naked puts, often the first line of defense is a roll down as stock valuations fall and place naked puts in the money. For those with credit put spreads often the fall of a stock can make rolling down more difficult if investors who sell credit spreads have sold more put credit spreads than they would normally have capital available to actually cover.
The dollar return or actual income earned is smaller on a put credit spread than on a naked put and many investors try to compensate by selling more put credit spreads to earn more actual income. Many investors read about the terrific returns investors seem to make on put credit spreads but those return percentages are from taking the amount earned and dividing it against the capital at risk, rather than the capital that may be required.
For example, an investor may establish a credit put spread on a stock with just a $2.00 spread. For example, selling the $42 put strike and buying the $40.00 put strike. This places $2.00 at risk plus the cost of the long puts less the amount earned on the selling of the short puts. If an investor earned 35 cents on such a spread after deducting the cost to buy the long puts, many investors will indicate they earned perhaps 17.5% on the trade as they take the 35 cents earned (including cost to buy the long put) and divide it against the capital they have at risk of loss. Sounds like a great return in theory.
The truth though is that the capital at risk versus the capital that may be required are two very different things. If the stock in my example fell to $40.00, the loss would be $2.00 less the 35 cents earned. But if the investor is trying to rescue the short side (puts they have sold), then the picture changes to reflect the short side cost.
I will delve more into credit put and call spreads in future articles and I will refer to this example again, but what this example is explaining is that when an investor establishes a put credit spread, the decision has been made at the moment the trade is placed, that a loss is possible on the trade. In my example, the loss would be $2.00 less 35 cents if the stock ends up at $40.00. That means when a put credit spread is put in place, the loss that is acceptable is $1.65 on each contract. On 5 contracts the loss would be 5 X $1.65 X 100 = $825.00. (for those new to options 1 contract = 100 shares which is why you multiply by 100)
To see how this can play out and what can be done to assist an investor when a credit put spread starts to have trouble, here is a question from an investor. This is question is typical of the many I received over the past several days so I thought I would work from this email. This is a long question but well detailed and worth reading fully before reading my answers. (items in brackets have been added by me)
I know you are looking at Visa trades for several investors and I was wondering if you could give me your opinion or ideas on my current trade. I originally started with a credit put spread of (8) contracts Apr 19 (expiry) $205 (sold)/$200 bought on 3/24/14 for a .36 premium (on $5 spread). On 4/4/14 when V was (about) $209 and still dropping I rolled the spread down to $200 (sold) /195 (bought) and out to April 25th and lowered the number of contracts from 8 to 6, for a small debit.
By Thursday this week (4/10) it was looking like this 200/195 might be in danger of ending up ITM by 4/25 and after reading some of your replies (or articles?) suggesting a rescue of breaking the spread apart and rolling the short side out while holding the long puts for further declines, I decided that was the best way to handle this in order to not lose some or all my $3000 capital at risk in the current spread so I rolled the short (6) puts out to May for a net credit of $1.67 and held the (6) long puts for Apr. 25th.
But with V still dropping, today, April 11th I rolled the short side out again to September and down to 195 strike for a net credit of $3.20 still keeping the (6) long April 25th 195 strike puts. Then a bit later I sold 3 of those long puts (too early!) for $3.50 when V had bounced back a bit to about $198. Unfortunately, those puts closed around $4.60 trading above $5 earlier in the day. I sold half thinking in case V bounced for a while back above $200, at least I would have some gain from the long puts. And if it continued to fall, I would sell the other (3) later for more.
So at this point I have (3) long April 25th 195 puts and (6) short Sept 20th 195 puts. My total net credit on the trade so far is about $4,150 lowering cost basis on the $195 short puts by ~$7/share to about $188)
Visa Stock Rescue Strategy on Credit Put Spreads
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