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Russell Rhoads is an instructor with The Options Institute at the Chicago Board Options Exchange. He is a financial author and editor having contributed to multiple magazines and edited several books for Wiley publishing. In 2008 he wrote Candlestick Charting For Dummies and is the author of Option Spread Trading: A Comprehensive Guide to Strategies and Tactics. Russell also wrote Trading VIX Derivatives: Trading and Hedging Strategies using VIX Futures, Options and Exchange-Traded Notes. In addition to his duties for the CBOE, he instructs a graduate level options course at the University of Illinois - Chicago and acts as an instructor for the Options Industry Council.

Russell:
Two weeks ago I discussed S&P 100 (OEX) index options as a good candidate for a first index option trade. In the comments for that article there was a request to show a trade using S&P 100 Index OEX options. Based on that comment I'm going to look at a basic bullish idea using weekly options that trade on the OEX. This example is also a method I use in my own trading when I have an opinion about the direction of the overall market. You can also think of this as a strategy to consider if you believe you have an opinion on the direction of the stock market for the next few days.

Since hindsight is 20/20 let's take a look at a bullish trade on the OEX from a couple of weeks ago. Below is a chart of the OEX From the beginning of 2012 through Thursday March 8. The OEX was around 618 after the market settled down after the open on March 8. The option prices used in this example come from just after the open on that day as well. March 8 is a Thursday and every Thursday there is always an OEX option series expiring the following Friday, either in the form of standard options or Weeklys. Barring a holiday this represents option contracts that have seven trading days remaining until expiration.

Extending the trend line forward by seven days would put support for the OEX at around 615, seven trading days into the future. Using this very basic outlook as the basis for a trade we could take a look at selling an OEX Put with a 615 strike price that expires on Saturday March 17 (trading through the close on March 16). This OEX March 615 put could be sold at $3.60. A short put is not appropriate for all traders. Often special brokerage approval is necessary to initiate a naked short option position. Combined with this short 615 put we could consider buying a 610 put at $2.50 or the 605 put for $1.60. Your decision would be based on your risk tolerance and how certain you are on the outcome of the trade. Selling the 615 put and buying either of the other contracts would result in a bull put spread.

For those of us that do not watch the market full time (that is we have a job to attend to) bull and bear spreads are one of my favorite suggestions for option trades. Your maximum risk is known along with maximum reward with one of these spreads. Also, you can actually profit if you are slightly wrong (this example is one of those cases). Finally, if constructed properly, you can get time decay working for you. Although these are all excellent reasons to trade bull or bear spreads, the ability to exit a position early always exists as well.

In this case we will buy an OEX March 605 put for $1.60 and sell an OEX March 615 put at $3.60. The net result is a credit of $2.00. Most option traders are aware the result here is a maximum profit of $2.00 as long as the OEX is over 615.00 at expiration. The maximum losses for this trade occurs if the OEX is at 605.00, or lower (a drop of just over 2%) at option expiration. Finally, a payout diagram for this trade if held to expiration appears below. Note on the payoff diagram that 618.00 (the price level for the OEX when the trade could have been initiated) is well within the maximum profit range at expiration.

Again, one of the nice things about this spread is the known quantity of potential profit or loss if the spread is held to expiration. However, what about when something changes and we decide it is time to exit the trade early. An example of this might be a break of the uptrend line in the OEX chart. If our long thesis for the market falls apart with a break of the uptrend, then we would want to exit the trade. Also we could have a 'mental' stop-loss price level where we would consider exiting the trade. Since the trend line on the chart is close to 610.00 we can use that for an example of our stop-loss price. The table below shows the profit or loss of the bull spread based on different levels for the OEX each day until expiration.

Note 610.00 using as a level where we exit the trade involves a losing trade anywhere between $2.00 and $3.00. Normally a vertical spread is approached with the risk/reward only being considered until expiration. If this trade is approached with the intent of holding to expiration the maximum loss is $8.00 while the maximum gain is $2.00. However, since this is a short-term trade consideration may be given to exiting early when it becomes apparent that the trade is not going to work out. If executed according to plan the maximum loss is $3.00 as opposed to $8.00 for a trade held to expiration.

Bull spreads are nothing new, but with the increased popularity of Weeklys options shorter-term bull spread trades are worth considering. This example shows a spread that would have a risk of $8.00 and reward of $2.00 if held to expiration, which is method most often used with approaching a vertical spread. However, with options that expire in just a few days always available for trading, the bull (and bear) spread may be approached with more of a short term trading mentality.

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Russell Rhoads can be followed on Twitter at twitter.com/RussellRhoads

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This complimentary article from Options Profits was originally published on March 21. Don't risk missing over 40 options trade ideas every week and exclusive commentary from over 15 experts. Click here for more information and a 14-Day Free Trial.

At the time of publication, Russell Rhoads held no positions in the stocks or issues mentioned.

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