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If you feel the stock is going to move down to $17.50, you don’t want to buy the $17.50 call, even if it gives you the right to buy the stock at $17.50.
Instead, a more attractive strategy is actually to put on a vertical spread, at the $17.50 level, on the put side. In other words, you would go here, at the $17.50, and you would sell a vertical spread.
This does a couple of different things for you. Number one – you can determine the number of shares that you actually want to buy. If you want this stock put to you at $17.50, you have to buy the stock. If you sell the $17.50 put, you have to buy the stock at $17.50.
Number one: You get the stock at the price you want. You get the price of the stock set for you, by the option that you sell. If you wanted the stock at $15, you would change the one that you sold, to the $15 level.
Now, you recognize the fact that when you’re selling a vertical spread, you receive a credit for this. Just like we do iron condors, we’re selling a vertical spread. We’re selling a vertical spread on the call side, and we’re selling a vertical spread on the put side.
In this case, the only thing that we’re doing, is selling a vertical spread on the put side, because we want to set the level at which we purchase the stock. If we think the stock is going to drop to $17.50, and we would be happy to own that stock at $17.50, then we sell a put.
What happens when you sell a put? Well, it gives the put buyer the right, but not the obligation, to sell the stock at $17.50. By being a seller of that put option, if they exercised their right – and they would do that, if the stock dropped to $17.50 or below. You would be obligated to purchase the stock at $17.50.
If we wanted to buy the stock at $15, we would sell a $15 put option, in order to purchase that stock at $15. We could just sell it. We could just sell that option. What does that do? Just selling the option, without the corresponding purchase of another option to protect that position, gives us unlimited risk.
Let’s take a look at the analysis again. What happens is, if we sold a put option, it gives us a little bit of premium here. It also gives us almost unlimited downside risk. I say almost unlimited downside risk because the stock can’t go below zero. It does give us a tremendous amount of risk on the downside, if the stock continued lower.
That’s why we always protect the sale of the put or the sale of a call, with an additional put, to protect our position. Let’s say we wanted to purchase the stock at $17.50. We would go ahead and sell a vertical spread at that level.
Let’s say we wanted to purchase 500 shares at that level, and we thought that was a very attractive price. Well, at this level, if we wanted to purchase 500 shares at $17.50, we can enter our order for a put spread, to sell the $17.50, and then purchase the $15 puts as protection against that.
Here’s what happens when we analyze this particular trade. If the stock moves up, we make our maximum profit, of $195 on 5 contracts. If the stock drops – what will happen is, if it drops below our $17.50 that we want to purchase – we’re going to get that stock at $17.50, if it drops below $17.50 at expiration. At the same time, we’re also going to be protected with the July $15 put. We will be long 500 shares of CitiGroup at $17.50. We will have our protected put in place, at the $15 level.
That does not give us 100% protection, but it does give us some protection, if the stock should move even lower than that. If the stock does not fall to $17.50, and continues to move up, against our position, we still make money. Like I said, we get paid for waiting. We get paid for waiting for the stock to drop to $17.50.
For the month of July and these July expirations, which is about – we have 27 days left in July. We would get paid $195 for 27 days, just to wait until the stock dropped to the price that we wanted. It’s as simple as that.
If, for some reason – let’s say somebody who purchased the $17.50 puts, wanted to exercise their options prior to the expiration date – we get to keep the premium. We sold those 17.50s for 69 cents. We actually get to keep the premium from that sale. We would also have the stock at the price that we wanted, if we wanted it at $17.50.
The reason I say that this is really an explosive strategy for people who have a little bit more capital to work with – if this $17.50 put is exercised, you will have to buy the stock at $17.50. If you sold 5 puts at the $17.50 level, you’re going to buy 500 shares at $17.50. At $17.50 times 500 shares, you’re looking at an investment of about $8,750, which is not too bad. On margin, you would only have to put up about $4300.
You would have the stock at $17.50, which is a pretty attractive level. Let’s take a look at another stock. Before I do that, I just want to point something else out to you. This is a particularly attractive strategy if you want to bottom fish stocks. Rather than purchasing the stock outright, and you wanted to really take a look at a stock that has fallen dramatically – for example, CitiBank.
CitiBank has fallen dramatically here. You want to start bottom fishing to see if you can get it at a really good price, way down in here. The reason this is an attractive strategy for bottom-fishing stocks is because of the volatility. I just wanted to take a look at the volatility here.
The volatility on the July options is 79%. That’s the implied volatility. That’s relatively high, because the stock has fallen so much. What does that mean for the options?
The options will be more expensive, the higher the implied volatility. As the volatility increases, it also increases the price of these options. It actually increases the value of both the calls and the puts. We’re only interested in the puts at this time.
We can do some analysis here. Let’s go back to our Analyze tab for a second. We have a vertical here, that we can sell the $17.50 puts, and purchase the $15 put, for a credit of 39 cents. What happens to the price of this credit spread, if volatility were to decrease?
You can see that the Vega, the Theta, the Gamma, and the Delta are about 80.73 on the Delta. We’re slightly long Delta. That means, in other words, that we make more money as the stock increases. Our Theta is $3.18. That’s how much we expect to collect on a daily basis, getting closer to expiration.
Our Vega is a -3.69. In other words, if volatility were to decrease and we’re short Vega, we would actually make more money.