CASE STUDY — FB Dec 15 – 20 Put Spread — *closed*

| July 29, 2012 | 1 Comment More

Judging from the responses from last week’s Facebook (FB) earnings survey, some of you expect the stock price to suffer additional losses throughout the remainder of 2012. FB lost 11.7 percent and fell to new lows of $23.71. Meanwhile, the top options trades on the stock were part of a spread, in which the investor apparently bought 7,500 December 20 puts on FB for $1.80 and sold 7,500 December 15 puts for 50 cents. It appears to be a new position because volume exceeds open interest in both contracts. If so, it’s a bearish play targeting a possible move to the mid-teens by yearend. An investor with a large position in shares might have initiated the spread as a hedge.

The bear put spread is an example of a vertical spread because it uses options in the same expiration month but different strike prices, which are typically listed vertically on an options chain. In this 101 strategy, the investor is buying a put and also selling a lower strike put. The trade is initiated when the strategist expects the underlying to make a move lower. Rather than straight put buying, writing an additional downside put reduces the cost of the trade and will hedge some of the risk associated with time decay. The trade-off is that, if the underlying moves substantially lower, there is limited profit potential because the lower strike put is likely to be in-the-money at expiration. If assignment comes into play, the position has reached its max profitability. The best gain from a bear put spread is the difference between the two strikes minus the debit. The risk is limited to the debit paid.

In this example, shares are trading for23.71 and FB Dec 15 – 20 put spread traded for 1.3. The risk to the trade is the debit paid, or 1.3 if shares hold above the higher strike or -15.6 percent below current levels . The breakeven is equal to the higher strike price minus the net debit, or 18.7 and -21 percent from current levels. The max profits happen if shares fall below the lower strike and equal the diff in the strike prices minus the debit, or 3.7. The OptionsXpress payoff chart shows the risk-rewards and probabilities of success graphically.



Trade Idea FB Dec 15 – 20 put spread
Bias = Bearish
Risk = Debit=1.3
Reward = Diff in strikes – debit =3.7
Breakeven=higher strike-debit=18.7
Target: December expiration
Stoploss: FB reclaims $30.5 per share

Download PDF –> FBDEC1520PUTSPREAD

closed — 8/2/12

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Category: Trading Education

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Frederic Ruffy is a well-known trader, writer, and strategist who has spent years educating investors and creating intelligent, insightful, unbiased market observations that are frequently cited by the Wall Street Journal and other financial publications. As senior analyst, Fred provides frequent and regular notes and daily updates for activity of interest.

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