Fri May 5, 2006: Selling Put Spreads (NASDAQ-PEIX)

Credit spreads on Pacific Ethanol (NASDAQ-PEIX) currently offer a high yield even with options that are relatively far out-of-the-money.

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 outlined in blue in the table below, PEIX June 30 put options are currently out-of-the-money by 5.24 points, or 14.9%.

Selling the June 30 puts and buying the June 25 puts to form a credit spread could return an income of 33.3% because the margin requirement is $375 per spread and the income is $125. The hope is that both puts expire worthless, which will happen as long as the price of PEIX stock is above 30 at the close of trading on expiration day Friday June 16th. As usual in this example we ignore commissions and slippage.

Calculate the break-even point:

30.00 - 1.25 = 28.75.

Between 28.75 and 30.00 you would still be in a profitable position but it would be less than $125 per spread.

Below 28.75 you will have a loss. The loss would be limited to $375 per spread because the long June 25 put option you bought would increase in value point for point with the June 30 put option you sold no matter how low the stock falls. In this way, owning the June 25 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 25. Of course this would generate an immediate loss of $500. Since you received $125 for selling the spread, your net loss would be $375.

If the stock finishes below 30 but above 25 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 instead of $35.24 which is today's price!

Even if the stock finishes below 25 you don't have to exercise your option, you could sell it instead and hold onto the shares of stock.

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