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If a stock is trading at $30 and I believe it will go no higher than $33, is there a spread that I can create above $33? This is a neutral to bearish strategy.

I've looked at a debt put spread:

sell $34 put
buy $37 put

They always end up with a negative profit potential or very small profit. Is there some spread that can work in this scenario? If not a spread, what is the better option strategy?

  • It's not clear what your objective is. If you are trying to capitalize on a rise to $33 then your proposed spread is inappropriate. The spread has other problems but I'm not going to make guesses without clarification. Why did you choose these strikes? – Bob Baerker Nov 12 '18 at 21:15
  • The strikes were chosen in an effort to maximize gain. – 4thSpace Nov 13 '18 at 0:43
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    @4thSpace , can you clarify. Do you think the stock is going higher? (I don't understand what you mean by "neutral to bearish".) – Fattie Nov 13 '18 at 3:55
  • @4thSpace - Why do you think that combination of strikes maximizes gain? – Bob Baerker Nov 13 '18 at 4:01
  • @Fattie - The information provided is insufficient to make realistic suggestions. At best, this spread could be a volatility play if a large IV contraction was anticipated but it's still chasing peanuts. – Bob Baerker Nov 13 '18 at 4:02
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Because your proposed spread is deep ITM, you are paying almost the intrinsic value of the spread because there's only a small amount of time premium. That means that you have a low delta, low expected profit position with a very asymmetric R/R with a high probability of capturing a small potential gain and a small probability of losing the large debit cost. So if the time premium involved was 30 cents, with a 3 point difference in strikes, ignoring slippage and commissions, you'd have to get this right 9 times out of 10 to break even. Not good odds.

Your spread might be acceptable if implied volatility was high (undisclosed by you), you were outright bearish and you were looking to capture a short term IV contraction. The higher the IV, the higher the small amount of time premium involved in this spread and the modestly lower your debit cost will be.

If you had a downside share price limit as well, say $27 which means that you expect a range of $3 on either side of the current price of $30 then a short Iron Condor might be appropriate since it benefits from time decay on both sides. In addition, if price moves against you, you might be able to roll the unaffected side in, bringing in some additional premium to slow the loss on the affected side.

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Indeed, being short volatility tends to produce a large chance of small gains and a small chance of large losses. You wish to profit by selling insurance on a relatively unlikely event (the stock rising more than 10%), but evidently people will not pay very much for this insurance.

A theoretically equivalent but more efficient version of your suggestion is a bear credit spread, short the $34 call and long the $37 call. The bid-ask will be narrower for these out-of-the-money options versus the in-the-money ones for the debit spread. This may slightly improve your profit potential. But ultimately to have more profit you would need to take more risk.

You said you want to bet that the stock will not go above $33. If, however, you specifically think the stock will rise but not that much, you could consider a plain covered call. This would have greater profit potential but would leave you more exposed to a potential decline in the stock.

  • "Indeed, being short volatility tends to produce a large chance of small gains and a small chance of large losses." thatt's pretty astute ! – Fattie Nov 13 '18 at 3:56
  • He said he's neutral to bearish but he doesn't see the stock rising above $33. The covered call is suitable for rising to $33 but not suitable for the undefined bearish outlook. – Bob Baerker Nov 13 '18 at 3:58

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