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NOTE: This graph assumes the strategy was established for a net credit.

The Strategy

This is an interesting and unusual strategy. Essentially, you’re selling an at-the-money short put spread in order to help pay for the extra out-of-the-money long put at strike A.

Ideally, you want to establish this strategy for a small net credit whenever possible. That way, if you’re dead wrong and the stock makes a bullish move, you can still make a small profit. However, it may be necessary to establish it for a small net debit, depending on market conditions, days to expiration and the distance between strikes B and A.

Ideally, it would be nice to run this strategy using longer-term options to give the stock more time to move. However, the marketplace isn’t stupid. It knows that to be the case. So the further you go out in time, the more likely it is that you will have to establish the strategy for a debit.

In addition, the further the strikes are apart, the easier it will be to establish the strategy for a credit. But as always, there’s a tradeoff. Increasing the distance between strike prices also increases your risk, because the stock will have to make a bigger move to the downside to avoid a loss.

Notice that the Profit + Loss graph at expiration looks quite ugly. If the stock only makes a small move to the downside by expiration, you will suffer your maximum loss. However, this is only the risk profile at expiration.

After the strategy is established, if the stock moves to strike A in the short term, this trade may actually be profitable if implied volatility increases. But if it hangs around there too long, time decay will start to hurt the position. You generally need the stock to continue making a bearish move well past strike A prior to expiration in order for this trade to be profitable.

Options Guy’s Tips

If you own a volatile stock, this is a potential way to protect your investment against a large downturn with a smaller cash outlay than it would take to purchase a put outright for protection.

This is a trade you might want to consider just prior to a major news event if you expect the outcome to be negative. Examples include pending FDA rejection of a “miracle drug” on a pharmaceutical stock or a bad outcome from a major legal case. A real-life example of when this strategy might have made sense was in the banking sector during the sub-prime mortgage crisis of 2008.

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