With the continued march to a world of sub-20% VIX1 readings, premiums required to purchase out-of-the-money debit spreads have continued to decline. Couple this lower premium with the almost 6% rise in the S&P 500 Index (SPX) since the start of this new year and you may discover some compelling trading opportunities.
Whether you believe an upside breakout may be coming or you are concerned about a possible retracement in market prices, lower-cost debit spreads may be one way to limit your risk while potentially profiting through a limited-risk limited-reward strategy.
Think about it this way: if your preferred strategy is to sell out-of-the-money SPY (SPDR S&P 500 ETF) puts as a strategy to gain neutral-to-bullish market exposure, the premium you now receive by selling put options is considerably lower than it was two months ago.2 You either have to sell options with strike prices that are significantly closer to being at-the-money (ATM)3 to receive the same premium, or you have to sell options that are the same distance out-of-the-money for much lower premium.
Is it worth it? The maximum reward for a short/sold put is limited to the premium collected upfront (while risk is unlimited down to zero). Perhaps the strategy is still worth it for some traders, but those concerned about the risk/reward of short options might look to the lower-volatility environment for current opportunities that are present in long debit call spreads. It may make some sense, because if options are too cheap to sell, they may be a value to buy. The risk to buying debit spreads is 100% of the premium paid, while the profit is limited to the difference in the traded options’ strike prices less this premium.
Conversely, if you don’t believe this rally, what could you do? Well, with the market run-up and the volatility decline, there are symbols on which you can buy debit put spreads that would be in-the-money if the underlying stock retraces back to trading prices just 30 days ago on January 1, 2012. The prices of these debit put spreads are now lower than they have been in the recent past and may once again provide compelling limited-risk, limited-return trades.
We have two useful tools to assist our traders in analyzing the possibilities:
The Trade Generator in our suite of platform tools has a debit-spread finder, which is ideal for scanning for these opportunities. You can access the Trade Generator from the latest version of the OptionsHouse platform by clicking on the Tools tab. You can also click on any down arrow, select Tool Navigator, and get to the Trade Generator from there.
The Debit Spread tool inside of the Trade Generator (which you can select from the strategy drop-down menu) allows you to search by industry group, Watchlist or a single security, for debit call spreads and debit put spreads based on your selected criteria. A comparison between historical and implied volatilities is generated and the ideas will populate based on maximum potential ROR.4
For example, say you think that Apple shares could retrace back toward the price the shares were trading on January 1st, 405.00. The Trade Generator highlights trades such as the April 12 420/415 debit put spread (going long the 420 put, shorting the 415 put) for $1.20 per spread. If AAPL is trading below $415 when the spread expires, the profit maxes out at $380.00 (before commissions). The risk is capped at the $120.00 premium paid. This represents a 316% return on risk on this trade.
We also have a Spread Investigator tool in our suite, which shows potentially inexpensive call and put spreads currently available in the market. This has less qualitative screening capabilities and is intended to show lower-cost debit spreads, which oftentimes are very far out-of-the-money (OTM5). Be forewarned, the farther out-of-the-money the spread is positioned, the lower the probability exists that they it become profitable at expiration.
In conclusion, this is not intended to be any sort of buy or sell recommendation but is rather aimed to stimulate your thoughts around trading the volatility environment that currently exists. When volatility levels are lower, it may make sense for long option spreads. For more information on vertical spreads check out our webinar archive for presentations on long call spreads and bear put spreads.
1 VIX CBOE SPX Volatility Index. An estimation of the current 30-day implied volatility in the SPX index options. Current level February 1, 2012 = 18.24
2 VIX level on December 1, 2011 = 27.41
3 ATM – At-the-money options are those with strike prices very close to the current underlying price.
4 ROR – Return on risk, or the total maximum profit potential divided by the maximum risk of loss.
5 OTM – Out-of-the-money option spreads are those with strikes prices that are higher than the current underlying price for calls and lower than the current price for puts.
We talked about “Expiration Week Earnings Plays” in this week’s webinar (you can access an archived version from 
Investors may have a renewed interest in U.S. Steel (NYSE:X) Corp. this week after a Goldman Sachs analyst upgraded the stock. The covering analyst booted his overall rating to “buy” from “neutral,” lifted his earnings forecasts through 2013, and raised his 12-month price target by 23% to $75.
Watch for falling stock prices? Goldman Sachs recently expressed bearish sentiment on Wal-Mart Stores (NYSE:WMT), downgrading shares of the retailer to neutral from buy. Reasons for the downgrade included inflationary risks in the food and apparel sectors, which could limit margin upside. Goldman analysts also opined that the sheer size of WMT limits growth potential for same-store sales.
Iron condor spreads are option-trading strategies combining two credit spreads (one bull put spread, one bear call spread) into a four-legged strategy with limited reward and limited risk. Largely because of their finite risk, iron condors are popular among investors seeking investing alternatives for range-bound stocks or indexes. Potential reward and potential risk aren’t the only factors that are limited in this strategy; generally the investor is anticipating limited movement in the underlying as well.
