What’s the downside to the short put? If
the stock rallies past $20.40, then the profit
on the stock would be greater than the profit
on the short put. The long shares theoretically have unlimited potential profit. The short
put is also not eligible to receive any dividends, and can incur higher commissions.
The naked put strategy also includes a high
risk of purchasing the corresponding stock at
the strike price when the market price of the
stock will likely be lower.
BEARISH—Short Shares vs. Short Call
If you think a stock’s price will drop,
the traditional strategy is to sell its shares
short. If the stock’s price drops, the trade is
profitable. If the price rises, the trade loses
money. The max profit is the stock price itself,
which happens if the stock price goes to zero.
If you shorted 100 shares of an $80 stock, the
max profit is $8,000, not including commissions. However, the short stock position theoretically has unlimited risk: there’s no limit to
how high the stock’s price might go.
The bearish alternative could be a short
call vertical (Figure 2). Sell short an OTM
call and buy long a further O TM call in the
same expiration, and you receive a credit
for selling the call vertical. For example, on
a stock trading at $80, a short call vertical
might be to sell the 82 call and buy the 84
call for a $0.65 credit. The max profit on the
short 82/84 call vertical is your $65 credit.
Max profit occurs if the stock closes below
$82 at expiration. The breakeven point is
the short call strike ($82) plus the credit
($0.65), which is $82.65. If the stock is anywhere below $82.65 at expiration, the short
call vertical has some profit.
The max loss is the difference between the
strikes ($84 – $82) minus the credit ($0.65),
which in this example is $135. This occurs if
the stock closes above $84 at expiration.
Compare the $65 max profit on the short
call vertical to the potential profit of shorting the stock. If the stock price drops below
$79.35, the short 100 shares make a larger
profit than the short call vertical. But what
if the stock rallies, say, 5% and goes from
$80 to $84? The short 100 shares would lose
$400, and the short call vertical would lose
$165, not including commissions. And what
if the stock price rose to $82? The short 100
shares would lose $200, and the short call
vertical could still make $65.
In this example, the short call vertical can
profit if the stock closes anywhere below
$82.65 at expiration, while the short 100
shares only make money if the stock is below
$80. The short call vertical has positive time
decay, and can make money if the stock price
stays at $80 as time passes, all things being
equal. So, in theory, the short call vertical has
more opportunity for some profit than the
Just like the bullish short put, there are
downsides. The short call vertical has smaller potential profit and potentially higher
commissions than the short stock position.
NEU TRAL—No Trade vs. Iron Condor
When you don’t think a stock’s price
will change, there’s no traditional
strategy. Maybe you buy the stock and collect
a dividend, but that’s still a bullish trade. For a
trade that could profit if the stock price doesn’t
move, you might consider using options.
The classic neutral options trade is the
iron condor—a short OTM call vertical, and
a short O TM put vertical, in the same expiration (Figure 3). You take in a credit when you
sell the iron condor. The speculation is that
the stock price will stay above the short put
strike and below the short call strike, and you
hope to keep the credit as profit.
For example, if the stock price is $100, an
iron condor might be long the 96 put, short
the 97 put, short the 103 call, and long the
104 call, for a credit of $0.35. The max profit
is the $35 credit, less transaction costs, if the
stock closes between $97 and $103 at the
option’s expiration. The iron condor has two
breakeven points: the short put strike ($97)
minus the credit ($0.35) and the short call
strike ($103) plus the credit ($0.35), or $96.65
The max possible loss is the difference between either the call strikes ($104 – $103), or
the put strikes ($97 – $96), minus the credit
($0.35), which is $65 in this example. The
max loss happens if the stock closes either
below the long put strike, or above the long
call strike at the options’ expiration.
Although the max potential profit on
the iron condor is limited, so too is the max
possible risk. Because the iron condor has
positive time decay, the position can result
in a profit as time passes, so long as the stock
price stays within a narrow range, all things
being equal. A downside of the iron condor
is that it’s a four-leg strategy that can entail
substantial transaction costs, including
commissions. Still, it’s a strategy that has
the potential to make money through speculation that the stock’s price won’t move up
or down much.
THE ROAD LESS TRAVELED
These alternative strategies aren’t your only
choices, but you can engage them if you’re
not confident in your directional strategy. If
you like the idea of lower risk, positive time
decay, and higher chances of making money,
then these other trading approaches might
be worth the downside of lower potential
profit and higher commissions.
Thomas Preston is not a representative of
TD Ameritrade. The material, views, and opinions
expressed in this article are solely those of the
author and may not be reflective of those held by
TD Ameritrade, Inc.
For more on the general risks of trading and
trading options, see page 37, #1– 2.