- 1999: Volume 8, No. 5 Swing Trading and Underlying Principles of Technical Analysis

"I tried to pick the market top and bought puts. That was six months ago. Then I tried to pick the top again and bought more puts. That was three months ago. Today I'm still bearish, but I can't afford to buy any more puts. What can I do?"

Buying puts is less risky than shorting stock or index futures, but, as this unfortunate trader has learned, buying puts still results in a loss if the underlying stock or index rallies.

This article will explain how volatility put spreads can be used as a low-cost alternative to buying puts outright. As you will see, these spreads might profit less than an outright put purchase if the underlying stock or index declines, but they are also likely to lose less if the market rallies.

In order to simplify the computations, commissions, fees and taxes have not been included in the examples in this article. These costs will impact the outcome of all stock and options transactions and must be considered prior to entering into any

transactions. Investors should consult their tax advisor about any potential tax consequences. The examples in this article do not include commissions or margin requirements. Since spreads involve multiple option positions, commissions and margin requirements can be higher than for single option positions.

Volatility Put Spread Defined

A volatility put spread involves the sale of one put and the purchase of two puts with the same underlying and same expiration but with a lower strike price. "Volatility" is in the name, because this strategy profits from a "large price change" in the underlying stock or index, i.e. high volatility.

The graph in Figure 1 illustrates an OEX 690-700 Volatility Put Spread in which one OEX 700 Put is sold for 15 and two OEX 690 Puts are purchased for 10 each. The spread, therefore, is established for a net debit (amount paid) of five, or $500, not including commissions. This is one-third the cost of purchasing the 700 Put outright, and one-half the cost of purchasing the 690 Put outright.

Profit/Loss at Expiration

The straight line in Graph 1 illustrates the potential profit and loss at expiration when there are three possible outcomes. The OEX can be at or above the higher strike, below the higher strike but not below the lower strike, or below the lower strike. If the index is at or above the higher strike at expiration, then all puts expire worthless, and the full amount paid for the position, five in this example, is lost. five, however, is not the maximum potential risk of this strategy! The maximum risk will be calculated shortly.

Figure 1

If the index is below the higher strike, but not below the lower strike, then the short put (higher strike) is assigned, and the two long puts (lower strike) expire worthless. In Figure 1, for example, if the OEX is at 695 at expiration then assignment of the 700 Put results in a debit, or cash payment, of five, or $500. The 690 Puts expire worthless, so the net profit or loss is calculated by adding the cost of the position, five, to the debit of five for a total loss of 10 or $1,000.

The maximum loss occurs if the index is exactly at the lower strike at expiration. With the index at 690 at expiration in this example, assignment of the 700 Put results in a debit of 10. The 690 Calls expire worthless with the index at 690 at expiration, so the debit of 10 is added to the initial debit of five for a total loss of 15. The graph in Figure 1 confirms that 690 is the index level at expiration where the maximum loss occurs.

If the index is below the lower strike at expiration, then the short put (higher strike) is assigned, and the two long puts (lower strike) are exercised. As the graph illustrates, either a net profit or a net loss can result if the index is below the lower strike. If the index is at 685 at expiration, for example, then assignment of the 700 Put results in a debit of 15 and exercising the two 690 Puts results in a credit of five each, or 10 total. These two events close the position and result in a net debit of five, or $500. The final result is calculated by adding credits (amounts received) and subtracting debits (amounts paid). In this case, with the index at 685, the initial net debit of five is added to the closing net debit of five for a total loss of 10, not including commissions.

A net profit is the result, however, if the index is at 660 at expiration. In this case, the 700 Put is assigned for a net debit of 40, and the two long 690 Puts are exercised for a credit of 30 each or 60 total. These two events close the position and result in a net credit of 20 or $2,000. The net profit is then calculated by subtracting the initial net debit of five from the ending net credit of 20. The result is a net profit of 15 or $1,500, not including commissions.

Breakeven Points and Maximum Profit Potential

In the graph in Figure 1, the volatility put spread breaks even at 675 at expiration. This is calculated by subtracting the maximum potential loss of 15 from the lower strike of 690. Below an index level of 690 at expiration, the net position is long one 690 Put, because the short 700 Put is offset by one of the two long 690 Puts. The rise in value of the second long 690 Put equals the maximum potential loss of 15 at the break-even index level of 675 (690 - 15). Below the breakeven point, the profit potential is substantial.

Price Behavior

Table 1 contains theoretical values of a 690-700 Volatility Put Spread at various index levels and days to expiration. This table was created using standard option pricing software. The value in each box assumes that one 700 Put is sold and two 690 Puts are purchased. Column 1, row 7 in Table 1, for example, assumes an index level of 660, 30 days to expiration. The assumptions about volatility, dividends and interest rates are stated in the heading of the table. Although the individual put values are not shown, selling one 700 Put at 41 1/4 and purchasing two 690 Puts at 32 3/4 each results in a net debit of 24 1/4, not including commissions, and 24 1/4 is the number which appears in this box. Consequently, given the assumptions stated above, the strategy could be established for a net debit of 24 1/4 or closed for a net credit of that amount not including commissions.

Table 1

Theoretical Values of 690-700 Volatility Put Spread (Short 1 700 Put and Long 2 690 Puts) (Dividend Yield, 1.5%; Interest Rates, 5%; Volatility 20%)
		1	2	3	4	5	6	7
	Index Level	30 Days	25 Days	20 Days	15 Days	10 Days	5 Days	EXP
1	720	+1 3/8	+3/4	+1/8	-3/8	-5/8	-1/2	0
2	710	+2 3/4	+2	+1	+1/8	-5/8	-1 1/4	0
3	700	+5	+4	+2 3/4	+1 1/2	+ 1/8	-1 5/8	0
4	690	+8 1/8	+7	+5 5/8	+4 1/8	+2 1/4	-3/8	-10
5	680	+12 3/8	+11 1/4	+9 7/8	+8 3/8	+6 1/2	+3 3/4	0
6	670	+17 3/4	+16 3/4	+15 1/2	+14 1/4	+12 5/8	+10 7/8	+10
7	660	+24 1/4	+23 1/4	+22 1/2	+21 5/8	+20 5/8	+19 7/8	+20
8	650	+31 3/4	+31 1/4	+30 5/8	+30 1/8	+29 3/4	+29 3/4	+30
9	640	+40 1/8	+39 7/8	+39 5/8	+39 3/8	+39 1/2	+39 5/8	+40
Note: Numbers preceded by a "+" indicate the spread can be established for a net debit and closed for a net credit. Numbers preceded by a "-" indicate the spread can be established for a net credit and closed for a net debit. Transaction costs are not included.

Numbers preceded by a "+" indicate the spread can be established for a net debit and closed for a net credit. Numbers preceded by a "-" indicate the spread can be established for a net credit and closed for a net debit. Transaction costs are not included. Table 1 can be difficult to interpret. Calculating profit or loss requires knowing the cash debit or credit when a position is opened and when it is closed and then adding them together correctly.

The conclusion from Table 1 which is supported by the graph in Figure 1 is that volatility put spreads perform best when the underlying falls sharply beyond the break-even point. If the market trades in a narrow range around the lower strike, then volatility put spreads will result in a loss.

Testing Scenarios

Tables such as Table 1 can be used to test various scenarios. Suppose, for example, that a decline in the OEX from 710 to 680 in 10 days is forecast. If today is 30 days prior to expiration, then this situation is consistent with column 1, row 2, in Table 1. The 690-700 Volatility Put Spread can be established for a net debit of 2 3/4.

If the index declines to 680 in 10 days as forecast, then Table 1 indicates that the position can be closed for a net credit of 97Ú8 (column 3, row 5). Establishing a position for a debit of 2 3/4 and closing it for a credit of 9 7/8 results in a profit of 7 1/8, not including commissions.

Now consider the risk. If the index rises instead of falls, then the risk of this volatility put spread is 2 3/4 plus commissions. This risk is substantially lower than the cost of the 700 Put of 10 3/4 or the cost of the 690 Put of 6 3/4.

Summary

Volatility put spreads involve the sale of one put with a higher strike and the purchase of two puts with the same underlying and same expiration but with a lower strike price. The risk of loss of these spreads is limited, but it can be greater than the debit amount paid to establish the position.

The ideal scenario for a volatility put spread is for the underlying index to decline sharply below the strike price of the long puts. Various forecasts can be tested by using theoretical value tables, but be careful when interpreting the numbers. Calculating profit or loss requires the proper adding of debits and credits.

Note: Options involve risks and are not suitable for everyone. Prior to buying or selling options, an investor must receive a copy of Characteristics and Risks of Standardized Options. Copies may be obtained from your broker or from The Chicago Board Options Exchange at LaSalle at Van Buren, Chicago, IL 60605.

Any strategies discussed, including examples using actual securities and price data, are strictly for illustrative and educational purposes only and are not to be construed as an endorsement, recommendation, or solicitation to buy or sell securities. Past performance is not a guarantee of future results.

James B. Bittman is an instructor with The Options Institute (the educational arm of The Chicago Board Options Exchange) and the author of Options for the Stock Investor and Trading Index Options (a Traders' Library "Best Seller").

He will be a featured presenter at the 21st annual Technical Analysis Conference (TAG 21) taking place at the MGM Grand in Las Vegas from November 19-22, 1999. For registration or program information, call 888-TAG-0858.