Out-Of-The-Money Put Time Spreads

A great way to hedge downside risk in equities or to speculate on a
major market decline is to buy deep out-of-the-money put time spreads,
a simple but very powerful trading strategy that gets you long
volatility and short delta without too much risk. This article
discusses the setup for the trade, the option strategy and the
projected profit/loss scenarios given different assumptions about
changes in implied volatility and movement of the underlying.

The Setup
Let's assume there is currently a bear market rally that began a few
months ago and that it is not the last. What if the next swing lower
will be the biggest in a final washout of the longs? How could we
capitalize on such a scenario without risking too much capital? One
way is to buy deep out-of-the-money put spreads. There are two
necessary market conditions to make such a trade worth the risk.

The first condition is low implied volatility, and we use the VIX (S&P
100 Implied Volatility Index) as a proxy for overall equity-market
implied volatility. When it is low, investors are complacent, and put
options are "cheap". When it is high, put option premiums go sky-high
as investors and money managers buy up puts in a panic to protect
stock positions. Put options give the owner the right but not
obligation to sell stock at a specific price (known as a strike price)
within a certain time frame.

We want options to be cheap in terms of the implied volatility pricing
because the trading strategy explained below is actually long vega (a
measure of risk exposure to changes in implied volatility), which
means it will profit from a rise in implied volatility. If VIX rises
with a sharp sell-off, the position will gain from any associated rise
in volatility. And if it is net short delta (a measure of risk
exposure to changes in the price of the underlying), a fall in price
will yield further gains.

The second condition we need is of course an overbought market. Here
we can use contrary sentiment indicators to tell when to enter this
type of trade. When the level of bullish investor and trader sentiment
gets too high, suggesting that the majority of market participants are
bullish, almost inevitably the market reverses direction and catches
the longs in a squeeze. When the majority of traders are long, they
are usually wrong, especially when there is heavy volume.

*The Strategy*This bearish strategy is simple to implement. It is
actually a calendar spread (also known as a time spread), but instead
of its usual placing at the money, it is placed deep out of the money.
At-the-money time spreads are usually placed when the trader expects
sideways movement of the underlying. Since it is a put time spread, it
will be placed well below the market place, assuming we have a bearish
outlook of course.

In June 2003, the S&P 500 was trading just above 990. At such a time
we'd want to place our put time spreads down below the latest
significant lows, which means below the lows of the last March
(787-8). Ideally we would want the market to go all the way down to
the strike price we'd select for this trade, but profit would arise
even with a less severe drop in the S&P 500, as you will see below.
Meanwhile, even if the market moves higher in the short term, the
potential for profit remains until the third Friday of September.
A long calendar, or time spread, involves selling a short-dated option
and buying a long-dated option, both at the same strike price. Since
the long-dated option has more time premium than the short-dated one,
the spread generates a debit to your trading account. You are buying
the more expensive and selling the cheaper for a debit. So this is
actually a net buying strategy. Let's take a look at how the pieces of
this strategy fit together with some actual prices.

Figure 1 below presents settlement prices taken at the close of
trading June 4, 2003:
* *The settlement price of the September S&P futures on June 4, 2003,
was 985.1. December S&P 500 futures settled at 983.40. The September
option is priced according to the level of the September futures,
and the December option is priced based on the level of the December
futures contract.

When initiating such a position, we would be selling the September S&P
700 put for $1.10 and buying the December S&P 700 put for $3.60. This
generates a debit of $2.50 in premium. S&P options are valued just
like the S&P futures, $250 per 100 basis points, or one premium point.
The maximum risk, therefore, is $625. This is the amount of money,
moreover, that would be required by the exchange to initiate this
trade. The risk is measured by the size of the spread (2.5). If the
spread widens, the position profits. If it narrows, the position

The nice feature about this trading strategy is that the spread can
only go to zero, meaning you can only lose $625. The spread would
narrow if the market rallied higher. Should the market trend lower
between the time of this trade and September expiration, a huge profit
potential exists. Figure 2 below presents a profit/loss snapshot of
this trade based on the assumption that there will be no change in
implied volatility. After we take a look at this scenario, we will
relax the no-change-in-volatility assumption, permitting a 10% jump in
volatility, which is conservative if we expect that the S&P might
break new lows.
* *
As can be seen in Figure 2, the position has some nice profit
potential should the S&P 500 get down to new lows before September
expiration, with maximum profit at the level of 700, totaling $15,750.
This example excludes commissions and fees, which can vary from broker
to broker. As indicated below in the profit/loss chart, the delta gets
shorter and shorter until we reach 700, where it reaches a maximum.
Meanwhile, the vega remains positive, so if volatility increases from
such a fall in the equity markets, the position gains. Figure 3 below
shows the profit/loss functions resulting from a 10% jump in implied
volatility of S&P 500 options, where we have now relaxed our
* *
With a ten-percentage-point increase in implied volatility, the
at-expiration level has increased to $19,180. One of the best features
about this trade is the potential for profit at levels well above 700
level at September expiration. For example, at 879-80 levels, we show
a profit of $3,025 with the assumed change in volatility, and $975
with no change in volatility. The actual profit would lie somewhere
between the two. This strategy can be applied in longer time frames as
well, such as March/December, and shorter-term selling strategies can
be employed to offset the cost of these bear market/crash protection
trades should the anticipated move not materialize. In the case
presented in this article, we used just a one-lot position. A trader
should scale position size according to risk tolerance and available
capital. Be aware that this trade requires closing the long December
put option at expiration of the September put option. The profit/loss
scenario changes should you chose to hold the long December put
*The Bottom Line*Deep out-of-the-money put spreads require low
volatility and potential for big downside moves to be profitable. Risk
is limited to the initial debit so there is no need to make
panic-driven decisions during the life of the trade. By selling a
short-dated deep out-of-the-money put option and buying a long-dated
option at the same strike, we are long the time spread, and the
account is debited to enter the strategy. An explosive move lower at
any time before September expiration (third Friday of the month) will
likely produce a profit. If you want to protect an equity position, or
speculate on another bear market decline, this might be your best
approach in terms of risk/reward.

*by John Summa*,CTA, PhD, Founder of OptionsNerd.com and
HedgeMyOptions.com (Contact Author | Biography)
John Summa, Ph.D., is the founder and president of OptionsNerd.com
LLC. He co-authored "Options on Futures: New Trading Strategies and
Options on Futures Workbook" (2001). He is also the author of "Trading
Against The Crowd: Profiting From Fear and Greed in Stock, Futures and
Options Markets" (2004), which presents contrarian sentiment trading
indicators and trading systems for stocks, futures and options.
Founded in 1998, OptionsNerd.com provides professional training and
educational support to stock, options and futures traders. Summa is an
economist, author, options trader and former professional skier, and
he presents small-group, online and in-person training seminars.
Source: Investopedia.Com