Trade Review on SPY 125/120 Vertical Spread

So we have a trader that was bearish on the market and more particularly the SPY.  Using the world of options he had several plays he could choose from to play the market lower.  He decided to go with a vertical spread over a straight long put to help cover the cost.  The cheaper spread comes with the disadvantage of limiting the profit.

The Setup: Buy December 125 Puts and Sell December 120 Puts
Play: Vertical Spread
Bias: Bearish
Price: 1.95

His max risk (max loss) is the amount he paid, or in this case 1.95.  His max profit is 3.05 (125 – 120 – 1.95).  When setting up a vertical spread is important to pay attention to this ratio.  The max reward over max loss gives you your reward/risk ratio.  Why is this important?  When setting up spreads it is ideal to make sure your return will be over your risk.  In this case we have a 1.5 reward/risk ratio.  

His break even on the trade is 123.05 (125 – 1.95).  Remember when dealing with options the profit/loss graph, break even, max profit, etc… occur at expiration.  Until expiration we can get a variety of prices and numbers.

When puts move quickly into the money they tend to lose time value premium very quickly.  They will actually lose time value premium a lot quicker than calls would.  So when the SPY fell to 117 in the course of 7 days we saw the spread widen to almost full profit.  Even though we still has 3 weeks till expiration the spread now traded for 2.88.  

Our trader chose to close out half his position at 2.88.  He did this to lock in his current profit while still remaining in the trade to seek out full profit.

Let’s review this.  The market has dropped 7 days in a row blowing through the short put strike.  If it remains under this strike (120) for another 18 days (time till expiration) he will be able to lock in the full 3.05 for the remaining contracts.  However, at 2.88 he has locked in 94% (2.88 / 3.05) of his potential profit.  He is now holding out for the remaining 6% or .17 in profit.  Given the current market, the possibility of getting out of the position with 94% profit, and the time remaining it is advisable to go ahead and close out your total position.  Risking your gains for an extra 6% profit is not a solid reward/risk.

This was a solid and profitable play by this trader.  Great job!