Sorry!! The article you are trying to read is not available now.
Thank you very much;
you're only a step away from
downloading your reports.

9 Weeks to Better Options Trading: Back Spreads

By

Veteran options trader Steve Smith breaks down the back spread.

PrintPRINT
Immediately after the numbers hit, implied volatility in the May options dropped from 39% to 22%. As I wrote in an OptionSmith Alert that morning, "looking at the report, I think the stock should be down $50." You would have had to be awfully quick though, and I wasn't nearly so on getting out of the long side of a broken butterfly, but with the stock near $650 on the open, one could have:
  • Sold 1 May $630 put at $12 a contract
  • Bought 4 May $600 puts at $3.50 a contract
This is a $2 net debit (4 x $3.50 = $14, and $14 - $12 = $2). The notion is that if shares of Google kept going higher, the loss is limited to $2.

On Monday morning, with shares of Google dipping below $605, the $630 put was around $33, and the $600 put was around $15, making the position worth around $27, for a 1,250% increase. (Note: 4 x $15 = $60, and $60 - $33 = $27)

This is a bit of a rigged example, as these gains occurred on a huge move in the stock, and as implied volatility in the May options bounced back above 25% following the initial post-earnings decline. But the point is, it illustrates how the gain in implied volatility worked in conjunction with the directional move in the stock to generate a big gain.

This happened for two reasons.

First, an increase in implied volatility will pump up out-of-the money options more than in-the-money ones. So since we're long the out-of-the-moneys, an increase in implied volatility is clearly beneficial. Second, all things being equal, an increase in implied volatility increases the value of an option. Since we're long more contracts than short, we profit here as well.
No positions in stocks mentioned.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

Copyright 2011 Minyanville Media, Inc. All Rights Reserved.

PrintPRINT
 
Featured Videos

WHAT'S POPULAR IN THE VILLE