Advanced Options Trading - Bearish Brazil ETF Put Debit Spread Case Study

| About: iShares MSCI (EWZ)

We recently had a bearish Put Debit Spread (some of you may know this as a Vertical Put Spread) trade recommendation in ETF Tradr that I wanted to do a little post-mortem on today. On the first half of the trade we (myself and Andrew Hart co-manage this premium advisory program) took 43% profits in one day, and we closed the remainder of the trade for 100% profits on Thursday.

Actual iShares MSCI Brazil Index EWZ Trade on ETF Tradr Position Table

(Click to enlarge)

The trade signal was based on our Daily ETF Tradr system, which incorporates a smoothed optimized Stochastics (similar, but a bit different than Percent R), Exponential Moving Averages, and Negative Volume Index. We focus on a key group of less than 30 liquid ETFs in a variety of manners — with special attention paid to having ETFs in the screen list that differ in terms of trading performance (aka don’t all move in tandem).

Anyway, our bearish EWZ signal was confirmed for February 2. We decided to go for a February Debit Spread on EWZ, rather than just a straight Put Purchase, due to the higher price/higher volatility of the ETF and its options. Selling a lower Put against the one we purchased lowers the overall out-of-pocket cost and also basically gives us a synthetic entry point below the intrinsic value of the higher Put.

EWZ Daily Chart

(Click to enlarge)

We received an excellent question from a subscriber on the day of the trade about why we chose to do this Debit Spread instead of a straight Put purchase — here was some of my response that went to all the ETF Tradr subscribers in the Daily Portfolio Update.

From the February 2, 2011 ETF Tradr Portfolio Update:

"We had a great subscriber question today about why we chose to do a Debit Spread on EWZ rather than just buying the Feb 78 Put and other aspects of the trade — here is some of the trade choice rationale for all of our ETF Tradr clients: First, if you are unable or do not desire to trade the spreads, you are welcome on your own to purchase a single option outright when those recommendations come in (but for auto-traders it will be executed as listed on the alert).

Now, in this case, this is higher priced and more volatile ETF as we mentioned, so first off we lower the cost out-of-pocket by simultaneously buying one Put and selling another against it in 1 spread trade. In today’s trade we lowered the cost of the trade by over 10% by doing the Spread vs the straight Put. Now, we have limited our maximum profit on the trade by doing this … the most this spread can be worth is $8 (78 minus 70 spread) — however, with only paying $3.20 for the spread, our maximum profit is still a very healthy 150% or $4.80 (8 minus 3.2).

Additionally, we lowered the " cost of our bearish entry level on this position to about 74.8 (based on the average price our auto-traders were filled of 3.2), while EWZ was at the time at 74.83 or so. So basically the spread allowed us to the do the trade for no time premium in the options – and we like that. As far closing out the trade … these spreads should be done as 1 single trade. So when we close it out, we close out both legs also as a single trade.

This one moved quickly in our favor and is already over 20% + profitable as of today’s prices. If EWZ moves right down to the 70 level, a spread could potentially get a bit trickier than a normal Put, depending on how far we are from Expiration … but the premium on the 70 Put that we sold will eventually erode, and there is very little premium on the 78 Put that we purchased.

Just a few educational notes on our perspective of why spreads are very attractive at times and are a part of the current ETF Tradr portfolio."

So basically with Debit Spreads (our preferred method is to buy a deep in-the-money ITM option and sell an at-the-money ATM or out-of-the-money OTM option), you can make a strong profit (but the maximum gain is less than outright Call/Put purchase), lower your $ out-of-pocket cost, and get into a position for little or no time premium. There is risk on virtually every options trade, of course, no matter what strategy you employ.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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