## Friday, November 16, 2012

### Options 2.0 – Part 10. Long Put Spread.

Today I’m going to outline the second option strategy with two legs: the Long Put Spread.

Structure
The Long Put Spread consists of two legs; the Purchase of a Put option and the Sale of a Put option with the same expiration date and a lower strike price.

Application
A Long Put Spread is useful if you anticipate a (small) decrease in the price of the underlying asset.
A Long Put Spread can be used in three different ways:
• Defensive; both strike prices in-the-money;
• A consistent market price results in maximum profit upon expiration
• Offensive; highest strike price in-the-money, lowest strike price out-of-the-money;
• A consistent market price results in profit upon expiration
• The price must drop to the lowest strike price for maximum profit upon expiration
• Aggressive; both strike prices out-of-the-money;
• A consistent market price results in maximum loss upon expiration
• The market price must drop to the lowest strike price for maximum profit upon expiration

Investment
The investment amounts to the number of contracts you trade x the contract size  x the price of the Long Put Spread (= Price of purchased Put minus the price of the sold Put option). If you buy 10 Put options for 11.05 and you sell 10 Put options for 5.75 you pay a balance of 10 * 100 * (11.05 to 5.75) = 1.000 * 5.30 = 5.300 euros.

Margin
The Long Put Spread strategy has no margin obligation.

Break-Even Point
You’ll reach the break-even point upon expiration if the price of the underlying asset is equal to the strike price of the purchased Put option - / - the price you paid for the Long Put Spread.

Maximum Profit
The maximum profit in a Long Put Spread is limited. Upon expiration, the maximum profit is equal to the strike price of the sold Put option minus the exercise price of the purchased Put option minus the price you paid for the Long Put Spread.

Maximum Loss
Your maximum loss is equal to your investment. If the price of the underlying asset is equal to or higher than the strike price of the purchased Put option upon maturity, then no intrinsic value will remain for either Put option. The Put options will expire at 0 and you’ll lose your investment.

The advantage of the Long Put Spread is that a small investment can realise a high return at consistent market prices and / or small price decreases.

The disadvantage of the Long Put Spread is that if it expires at a price that is more than the highest strike price then you’ll lose the entire investment.

Example (based on closing prices of Monday 12th November):
The AEX lists 332.33 at this particular moment in time. Suppose we buy a Put option on the AEX-index with a maturity of one month and a strike price of 340.00 for a price of EUR 11.05. And we sell a Put option on the AEX-index with the same expiration date and a lower strike price of 330.00 for a price of EUR 5.75.
This Long Put Spread costs 5.30 (= 11.05 - 5.75).
One Long Put Spread requires an investment of EUR 530 (=1 x 100 x (11.05 - 5.75) = 100 x 5.30).
The Long Put Spread has an intrinsic value of 7.67 (= 340.00 - 332.33).
With this Long Put Spread you sell for a balance of 7.67 - 5.30 = 2.37 time value. At a consistent market price, this is accrued the more the maturity decreases.
At a consistent price you’ll realise a profit of 2.37 (=+45%).
The AEX price must increase by 2.37 (from 332.33 to 334.70 = +0.7%) upon expiration, in order to break-even.
Below 334.70 and you’ll realise a profit using this strategy.
Below 330.00 (-0.7%) upon expiration and you’ll realise the maximum profit using this strategy. The maximum profit is (340.00 - 330.00) - 5.30 = 10.00 - 5.30 = 4.70 at an investment of 5.30 (=+89%).

Upon expiration your results are as follows:
 AEX Price Long Put 340 Intrinsic Short Put 330 Intrinsic Long Put Spread Intrinsic Long Put Spread Profit Profit In EUR Comment 315,00 25,00 15,00 25,00 – 15,00 +4,70 +4.700 Max Profit 320,00 20,00 10,00 20,00 – 10,00 +4,70 +4.700 Max Profit 325,00 15,00 5,00 15,00 – 5,00 +4,70 +4.700 Max Profit 330,00 10,00 0,00 10,00 – 0,00 +4,70 +4.700 Max Profit 334,70 5,30 0,00 5,30 – 0,00 0,00 0 Break-Even 335,00 5,00 0,00 5,00 – 0,00 -0,30 -300 Max Loss 340,00 0,00 0,00 0,00 – 0,00 -5,30 -5.300 Max Loss 345,00 0,00 0,00 0,00 – 0,00 -5,30 -5.300 Max Loss 350,00 0,00 0,00 0,00 – 0,00 -5,30 -5.300 Max Loss

Pitfalls
The traditional pitfall for private investors using Long Put Spreads is to purchase "aggressive" out-of-the-money Put Spreads, in the hope that the price of the underlying asset falls sufficiently with time. Whilst the potential maximum yield is extremely high, the investor may lose sight of the fact that if the price remains constant then the entire investment evaporates.
Consider investing in more offensive or defensive Long Put Spreads instead, which may offer less in terms of maximum profit, but result in a much smaller loss (or even profit) at a consistent underlying asset price.

Please refer to the above table for sample calculations (upon expiration) of various Long Put Spreads on the AEX with a maturity of one month:
• For an aggressive Long Put Spread 320-310, the AEX must drop by 6.7% to 310 upon expiration for a maximum profit of 545% (8.45 as compared to 1.55).
• If the AEX lists more than 320 (-3.7%) upon expiration then the loss will be 100%.
• Break-even is reached at an AEX of 318.50 (-4.2%).
• For a defensive Long Put Spread 350-340, the AEX must rise by 2.3% to 340.00 upon expiration for a maximum profit of 27% (2.10 as compared to 7.90).
• If the AEX lists more than 350 (+5.3%) then the loss will be 100%.
• Break-even is reached at an AEX of 342.10 (+2.9%).

Webinar "Smarter Investing with Investment Tools"
On Wednesday 14th November at 20:00, the AEX College of NYSE Euronext in partnership with Finodex, will run a free webinar. You can subscribe up until 19:30 on 14th November via: http://www.aex.nl/aex-college/webinars/inschrijven.
Until then,

I wish you much success and plenty of fun with your investments!

Herbert Robijn is founder and director of FINODEX (www.finodex.com). FINODEX develops innovative online investment tools for private equity and options investors. These cutting-edge tools allow investors to make a comprehensive market analysis, complex calculations and appropriate selections, at just the touch of a button.