Example Bear Put Spread on S&P 500 Index (SPY)

10/08/2009 12:01 am EST

Focus: OPTIONS

This low-risk, potentially high-reward trade is a bet on a sharp correction in the broad market and in the SPDR S&P 500 Index ETF (SPY) in particular. S&P stocks are relatively expensive at these levels. The current P/E ratio for the S&P 500 is at 18 times the ten-year average earnings. This level is abnormally high and getting higher as companies are still reporting lackluster numbers. We are now heading into earnings season, which may provide some catalysts for a market drop.

SPY Debit Spread Trade Details

NOTE: Sell and purchase prices derived from the bid and ask, respectively, at the time of publication.

The SPY is currently trading at $105.69.

Debit Spread, Bear Put Spread:

  • Buy the December 98 put (out-of-the-money) for $2.12 per contract
  • Sell the December 97 put (out-of-the-money) for $1.91 per contract
  • Net debit of $0.21

Profit/Loss Details

The maximum risk for this spread is $0.21 per spread-the premium paid at the outset-plus commissions. In order for the investor to suffer the maximum loss, SPY will have to be trading above the 98 strike at December expiration. At this point, both puts would be out of the money, and therefore, worthless.

While this is a drop of 7% for the SPY from current levels, it is a modest risk to assume for the maximum potential profit, which is the difference between strike prices (1) minus the debit, or $0.79. This profit is 376% of the initial risk and is achieved if SPY is trading at $97 or below at December expiration. Profits well below this strike price are forfeited with the bear put spread strategy and are therefore not as aggressive as long puts.

The break-even price for this trade is $97.79, or the strike price of the purchased put minus the debit paid.

By the Staff at ONN.tv

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