How to Maximize a Bear Put Spread

12/28/2011 7:00 am EST

Focus: OPTIONS

Professional option trader Tyler Craig explains how he manages a popular option trading strategy to achieve maximum profit potential.

As traders, we all face the dual mandate of maximizing gains and minimizing losses. Long-term profitability is a byproduct of the simple formula: big winners + small losers. 

Unfortunately, the mere acknowledgement of such a trading aphorism is just the beginning. The devil, as they say, is in the details. And since nothing illustrates the details like an actual example, let’s walk through an attempt at maximizing gains on a recent bear put spread.

In accordance with my bearish disposition on VXX outlined in a November entitled The Comeuppance for VXX Bulls, I opted to enter a few bearish spreads including the purchase of some January 44-39 put vertical spreads on December 8 for $2.79. 

The max risk was $279 and the max reward was $221. The dual forces of contango and seasonality delivered a swift beatdown to VXX, dropping it from $43.50 on Dec. 8 to $36.25 on Dec. 20.

See related: The 4 Key Seasonal Trends for 2012

The vertical spread rose in value from $2.79 to $4.00 for a gain of 43%. With the underlying down eight days in a row and the spread boasting a notable gain, I faced the typical dilemma of deciding whether or not to take profits or adjust the trade.

I opted for the latter due to two primary reasons:

  1. The initial risk-reward of the position was $2.79 to $2.21—a ratio of 1.26 to 1. After the spread rose in value, the risk-reward became $4 to $1—a poor ratio of .25 to 1. Although I could have remained in the position in an attempt to capture the last $1 of profit, thereby “maximizing my gains,” the risk/reward ratio was less than ideal

  2. With the notable drop in VXX to $36, the Jan 44-39 vertical spread had moved $3 in the money. This had the effect of dropping the overall Delta of the position, making the additional accumulation of profits a slow process. At trade inception, the Delta per spread was -20.  Following the drop to $36, the net Delta had dropped to -13

To improve the risk/reward ratio, increase the net Delta of the position, and better maximize gains if the downtrend continued, I elected to roll the vertical spread down and out. That is to say, down to lower strike prices and out to a later expiration month. I closed the Jan spread at $4 and bought a February 38-33 put vertical spread for $2.85.

The new position offers a better risk/reward ratio $2.85 versus $2.15 and has a higher net Delta, allowing the accumulation of quicker profits if VXX continues to sink.

If you regularly employ vertical debit spreads and have yet to add rolling to your repertoire, consider this your invitation. It’s a tactic which strikes a nice compromise when faced with the dilemma of how to best maximize gains.

NEXT: Another Trader Weighs in on This Strategy

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[Editor’s note: The original article led to an interesting exchange between the author, Tyler Craig, and Mark Wolfinger, who has also written about option trading on MoneyShow.com. It adds further explanation of the option trading strategy, so we have re-printed it here.]

Mark’s response:

“I agree with the idea that vertical spreads (both debit and credit) should be in every trader’s strategy arsenal.

However, using a “down and out” roll as an example of a good method for maximizing profits doesn’t work for me. Rolling out should not be considered as a risk management tool.

In my opinion, what you really did was make two trades. You took your profits in the front-month trade and then decided to open a brand-new position (unrelated to the spread just closed).

The differences in our points of view may be subtle, but during my 36 years of options trading I’ve discovered that most folks who adopt the down and out strategy make poor trade decisions because they structure the new trade based on the price of the position being closed. It is far more efficient to make a clean exit. Then decide which (if any) spread to own for future gains.”

Tyler’s response:

“Good to hear from you, Mark. Thanks for the input. I pretty much agree with your points. Here are a few additional thoughts:

  1. Keeping in mind that the objective is to maximize gains and that my expectation is for the underlying trend to persist, I much prefer the closing of the existing debit spread when the majority of profits are captured (and the remaining risk-reward is unfavorably lopsided) and opening up a new spread offering a better risk-reward versus remaining in the initial position. Because it reduces the capital allocated to the trade, I think we could easily make the case it reduces risk (even though the new trade may be a lower-probability bet).

  2. I agree that the new spread should be opened up based on its own merits, not based on the value of the initial spread when exited. Whether or not a trader employs a roll order where they simultaneously close one spread and open another, or simply exit the first trade and take some time to reassess before re-entering the next debit spread, doesn’t make much of a difference. The net result is the same. They’ve effectively “rolled” from one spread to another.

  3. I also agree I simply made two separate trades. If traders confuse that reality when they start using rolling orders, then I too would encourage them to simply close the initial trade and reassess before taking further action.”

By Tyler Craig of TylersTrading.com

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