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A Complex Play for Complex Times

After attending the Los Angeles Times Investment Conference last weekend, we realized how important it is to break down complex option strategies in ways everyone can understand and use. So we'll take a gander at something a bit more sophisticated than usual: a bull put spread.

And while this may prompt the image of a dangerous, frothing canine, it's actually somewhat less perilous than that. Here's why.

In the meantime, keep the questions coming to the Options Forum and be sure to include your full name.

All Spread Out

I have two bull put spreads on Yahoo! (YHOO), selling an October 150 put and buying a 145 put, then selling an October 165 put and buying an October 155 put.

I see my options as three: hold until October expiration and hope Yahoo! closes above 160, with both trades earning a maximum profit; or close out now for a small profit. That is, close the short position and hope Yahoo! drops as it usually does near expiration; or, do something else called a "back spread."

And what is a back spread?

--Ed Peterson

Ed,

This week's theme should be this: while lots of things with options are doable, sometimes they shouldn't be done. Here's Ed Borgato of Javelin Partners hedge fund in Las Vegas to explain why:

Complexity increases risk. And you already have a good position on. Fooling with backspreads (we'll get to what those are) isn't necessary, creates more commissions and could eat into your returns. The question is whether or not to hold on to this Yahoo! position.

A bull spread is an option strategy that achieves maximum profit if the underlying, in this case Yahoo!, rises dramatically enough and maximum risk if the security falls precipitously. You buy an option with a lower striking price and sell one with a higher striking price, generally with the same expiration date. Either puts or calls can be used in this strategy.

But it seems you lack a basic opinion on the stock. I'm a guy who, for a living, sits around trying to design clever options strategies, but at the end of the day, the underlying stock matters. You need to have a point of view before you set up any option strategy.

The analogy is that I can take someone downtown here in Vegas and teach them the mechanics of how to put a chip on red. That's what I'm doing when I'm explaining how to set up a bull put spread. But I'm not helping them on the underlying bet.

You're "hoping" the stock stays above 160. When I did that Dell (DELL) trade I had a rationale behind it: Your option strategy needs to complement your fundamental work.

Assuming you are simply speculating on Yahoo! staying above 160 until October, then your bull put spread is fine as is. Especially in a stock like Yahoo!, you're smart to keep your bet boxed in, as they say in option parlance, with the lower strike puts to protect yourself.

(As an aside, options lingo has changed. When I started working at Lehman Brothers in the late 1980s, back then everything was a straddle if you bought or sold a call and a put at the same time. As the years went by, I found another generation of option traders calling it a strangle when they had different strike prices.)

As long as you have the long positions in Yahoo!, you can't lose more than the spread between the strikes, those 5 points. Let's say the stock goes to 100. If you want to buy Yahoo!, let it get put to you at 150 or 160. Or, you could sell the puts for a huge profit. That would shield you from the decline and now you'd own Yahoo! at 100.

If -- and this is a big if -- you believe Yahoo! is going to be above 160 in October, I'd keep the position. The 160s and 150s expire worthless, but I make more than I lose.

And if you own the 145s and 155s and the stock collapses, you're protected. Best to let this play itself out -- if you believe the stock will be above 160.

If you don't believe it, then close it out.

Word from the Field

For the record, we do get responses to the Options Forum, and a kind reader wrote in with some info for other TSC fans on the main options pricing formula:

One site I find very convenient for Black-Scholes calculations is http://www.fee.uva.nl/ae/amman/teaching/option.htm. . It is great for doing quick calculations. Since it uses Java script formulas, I have downloaded it to my own computer and run it as a local page without having to start Java. However, it cannot derive implied volatility.

Another site that is handy is the Chicago Board Options Exchange's option calculator , which will calculate implied volatility.

--Nathan Light

TSC Options Forum aims to provide general securities information. Under no circumstances does the information in this column represent a recommendation to buy or sell securities.

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