Fri May 25, 2007: Buying the Dip in NTAP Using Put Spreads

The stock of Network Appliance Inc. (NASDAQ-NTAP) closed today at $31.80 per share, down from its 52-week high of $41.56.

Let's look at an example of selling put spreads. This strategy might be attractive to an investor who wants to take a bullish position in the stock but also wants a safety margin and loss limit.

As shown in the table below, NTAP July 30 put options are currently out-of-the-money by 1.80 points, for a "safety margin" of 5.7%.

Selling the July 30 puts and buying the July 27.50 puts to form a credit spread could return an income of 22.0% because the margin requirement is $205 per spread and the income is $45, for each spread for 100 shares. The hope is that both puts expire worthless, which will happen as long as the price of NTAP stock is above 30 at the close of trading on expiration day Friday July 20th. As usual in this example we ignore commissions and slippage.

Calculate the break-even point:

30.00 - 0.45 = 29.55.

Between 29.55 and 30.00 you would still be in a profitable position but it would be less than $45 per spread.

Below 29.55 you will have a loss. The loss would be limited to $205 per spread because the "long" July 27.50 put option you bought would increase in value point for point with the "short" July 30 put option you sold no matter how low the stock falls. In this way, owning the July 27.50 put limits your maximum loss.

If the stock closes below 30 on expiration day you can be assigned on your short put, that is, the buyer of that put could exercise his or her option to "put" (sell) 100 shares per contract to you at a price of $30 per share. Your broker would automatically buy them in your account at that price no matter how low the market price is at that time.

You could also choose to exercise your right to put the 100 shares to someone else at 27.50. Of course this would generate an immediate loss of $250. Since you received $45 for selling the spread, your net loss would be $205.

If the stock finishes below 30 but above 27.50 it would not make sense to use your put option to sell the shares, you could just sell them at the higher market price, or hold on to them and console yourself that at least you bought them at $30 per share (effectively $29.55) instead of $31.80 which is today's price!

Even if the stock finishes below 27.50 you don't have to exercise your option, you could sell it instead and hold onto the shares of stock.

In summary, investors who are bullish on NTAP long-term but don't want to jump in on this dip can instead take some option income and wait patiently to see what happens. If the stock goes down then they can purchase it cheaper than today. If it doesn't, they can make 22% income.

Until next time, best of luck with your option investments!