Play Historic IPO for the Chance at Double-Digit Gains With Less Risk

A credit spread strategy known as a bull put spread offers traders all the benefits of put sellingwhile taking on less risk.

To initiate a bull put spread, the trader sells a put option and simultaneously purchases another put option on the same underlying asset with the same expiration date but a lower strike price. A net credit is collected, and while you generate less income than you would by selling a put alone, the purchased put acts as insurance against big losses.

Today, I want to look at a specific bull put spread trade in Yahoo (NASDAQ: YHOO).

Because we may be obligated to buy shares of the underlying stock or ETF with this strategy, it is important that we are quite willing to own the shares at the strike price of the put being sold. Therefore, I’ll take a moment to discuss why I am bullish on YHOO.

Yahoo owns a 23% stake in Chinese e-commerce company Alibaba, which filed for an initial public offering late Tuesday that could turn out to be one of the biggest in history. Alibaba handles more online transactions than Amazon.com (NASDAQ:AMZN) and eBay (NASDAQ: EBAY) combined, and will no doubt represent a threat to these rivals in the U.S.

Alibaba owns Alipay, which is similar to eBay’s PayPal and is popular among and trusted by Chinese consumers. It also owns part of Chinese mobile search company UCWeb, and the two companies just announced a joint venture to challenge Baidu (NASDAQ: BIDU) in China’s $2.5 billion mobile search market.

Alibaba earned $2.9 billion in the first nine months of its last fiscal year, ending in March. That was more than the combined income of eBay and Amazon for the same period.

I want to take advantage of the Alibaba IPO with a strategy that will allow us to potentially buy shares of YHOO at a discount.

As you can see in the chart below, the low of the past six months was slightly below $33 per share. YHOO is currently trading near $34, and I would be comfortable owning shares below $30, about 12% below recent prices.

YHOO Stock Chart

As I mentioned above, we’ll be initiating a bull put spread in which we will be net option sellers, generating a net credit on the transaction while defining our risk upfront.

Recommended Trade Setup:

— Sell to Open (STO) YHOO July 30 Put
— Buy to Open (BTO) YHOO July 27 Put
— Net Credit: $0.55 or better Good ‘Til Canceled (GTC)

If YHOO is below $30 when the puts expire on July 18, we will be obligated to buy 100 shares per contract at $30 per share. But because we received $0.55 per share in advance as premiumfrom the credit spread, the net cost per share will be $29.45 (not including commissions).

But here is the kicker: We cannot lose more than $2.45 per share ($245 per contract) on this trade no matter what happens. That’s because, with a bull put spread, the maximum loss is the difference between the two strike prices minus the net credit.

If YHOO is between $30 and $27 at expiration, we would be in the same position as if we had just sold a put, and we will take ownership of shares at a net cost of $29.45. However, if YHOO falls below $27, the gains from the long put would offset the losses in our assigned position.

If you only sold a naked July $30 put on YHOO, you would receive more premium, about $0.81 as I write this, but you would take on more risk. You would incur a loss at any price below your breakeven, $29.19 per share ($30 strike minus $0.81 in premium) in this example. So, with the suggested bull put spread above, you are “sacrificing” just $0.26 per share ($26 per contract) in income, but you lower your risk substantially.

If YHOO stays above the $30 short put strike price on expiry, both options will expire worthless, leaving us with the $55 in premium, which represents a 22% return on our risk capital of $245 in 72 days.

If you have questions or comments about trading credit spreads, please send them toeditors@profitbletrading.com.

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