Front Spread w/Puts
AKA Ratio Vertical Spread
NOTE: This graph assumes the strategy was established for a net credit.
Buying the put gives you the right to sell stock at strike price B. Selling the two puts gives you the obligation to buy stock at strike price A if the options are assigned.
This strategy enables you to purchase a put that is at-the-money or slightly out-of-the-money without paying full price. The goal is to obtain the put with strike B for a credit or a very small debit by selling the two puts with strike A.
Ideally, you want a slight dip in stock price to strike A. But watch out. Although one of the puts you sold is “covered” by the put you buy with strike B, the second put you sold is “uncovered,” exposing you to significant downside risk.
If the stock goes too low, you’ll be in for a world of hurt. So beware of any abnormal moves in stock price and have a stop-loss plan in place.
NOTE: All options have the same expiration month.
Who Should Run It
NOTE: Due to the significant risk if the stock moves sharply downward, this strategy is suited only to the most advanced option traders. If you are not an All-Star trader, consider running a skip strike butterfly with puts.
When to Run It
You’re slightly bearish. You want the stock to go down to strike A and then stop.
Break-even at Expiration
If established for a net debit, there are two break-even points:
If established for a net credit, there is only one break-even point:
The Sweet Spot
You want the stock price exactly at strike A at expiration.
Maximum Potential Profit
If established for a net debit, potential profit is limited to the difference between strike A and strike B, minus the net debit paid.
If established for a net credit, potential profit is limited to the difference between strike A and strike B, plus the net credit.
Maximum Potential Loss
If established for a net debit:
If established for a net credit:
TradeKing Margin Requirement
Margin requirement is the requirement for the uncovered short put portion of the front spread.
NOTE: If established for a net credit, the proceeds may be applied to the initial margin requirement.
After this position is established, an ongoing maintenance margin requirement may apply. That means depending on how the underlying performs, an increase (or decrease) in the required margin is possible. Keep in mind this requirement is subject to change and is on a per-unit basis. So don’t forget to multiply by the total number of units when you’re doing the math.
As Time Goes By
For this strategy, time decay is your friend. It’s eroding the value of the option you purchased (bad). However, that will be outweighed by the decrease in value of the two options you sold (good).
After the strategy is established, in general you want implied volatility to go down. That’s because it will decrease the value of the two options you sold more than the single option you bought.
The closer the stock price is to strike A, the more you want implied volatility to decrease for two reasons. First, it will decrease the value of the near-the-money options you sold at strike A more than the in-the-money option you bought at strike B. Second, it suggests a decreased probability of a wide price swing, whereas you want the stock price to remain stable at or around strike A.
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