A how to.
music selection: “Time Bomb” — Godsmack
A great way to use options is with net debit spreads. These combine the leverage of long contracts with the income of short contracts. They play both ends against the middle to create a hybrid instrument with defined risk, lowered cost of entry into a trade, and great profit potential. I am going to demonstrate a Bear Put Spread with Tesla (TSLA).
Say you are bullish on Tesla (TSLA) (and I am bearish on TSLA, I have a trade very similar to the one I demonstrate today already open and it is doing great) and want to earn some short term profit with only a few hundred dollars at risk. You can buy one put of TSLA and sell another at a lower strike to capture the spread between the strikes. The strikes could be out of the money if you want to try to knock it out of the park but I almost always go with both strikes in the money. This gives me some downside protection while still allowing remarkable earning potential.
For example, with shares currently trading at 215.96, you might go multiple strikes in the money and sell TSLA191018P00235000 for about 27.05 while simultaneously (always use a combo order) buying TSLA191018P00240000 for about 30.53. The net debit on the trade would be 3.48 and puts only $348 at risk per spread.
You now have the obligation to buy TSLA at 235 and the right to sell at 240. Simple arithmetic should make it clear that your net revenue from those transactions is 5 dollars. You spent 3.48 to get in so your profit is 1.52 per share or 43.68%. The trade would be in force for a maximum of 51 days meaning your annualized return is about 313%.
This profit is earned if shares fall, if they remain unchanged or even if they move against you (up) by as much as 19.04 before expiry (8.82%). Ordinarily a single put in TSLA would tie up 100 shares and thus cost you over 1,800 dollars for the at the money strike. You have only 348 of exposure to this trade but still have fantastic earnings potential AND downside protection if the trade moves against you up to almost 9%. You can gain even more downside protection by going deeper into the money at the cost of some of your return (but really the return is so high you aren’t going to be hurting) so if you are feeling conservative by all means do so.
You can try to knock it out of the park by buying a spread that is out of the money. If the contracts move into the money by expiry, your return will be VERY high. I just don’t think it is worth the risk of losing my entire 348 when I can make so much with a great deal of safety. The smartest lizards always protect their tender hindquarters!
I’ve had several emails asking about the mechanics of these trades so I’m glad to spell it out for anyone who is new to options. I’ll be back next Wednesday showing how a Calendar spread works to leverage the gain you can get from exploiting the decay of time value versus selling a covered call or cash secured put. These are powerful tools that need to be in your toolbox. Until then…
Devour your prey raptors!