16th March, 2007

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BUD ended the week trading at $49.64, which is 1.12% below our starting point last week of $50.20.

Source: Market Club

Despite the downward move, implied volatility has dropped about 1% to end the week trading at 15%.

The move was good enough to produce some tidy gains for my Put Backspread.

The option strategy was initially worth $310 credit per spread and is now trading at $250 credit. To trade out of the option spread will mean a $60 profit for every ratio spread established. Here are the option prices:

Source: VOptions

With such a small move in the underlying stock this option strategy has made a return on investment of 31.58%. This is what leverage is all about.

By "return on investment" I am talking about "return on maximum risk per trade", not the total account value. This is because when I buy a call option, my risk capital is the total premium paid as I cannot lose more than that amount.

However, with a credit spread such as a backspread the maximum loss is not the sum of the premiums. The maximum loss is calculated as the difference between the two strikes minus the net premium received. So, (55 - 50) - 3.10 = 1.90. When taking the multiplier into account the total is $190.

I also like to use a spreadsheet for calculating the maximum loss per option trade just to be sure. I've included an example for this trade here:

Download Payoff Spreadsheet.

Just enter your option parameters into the yellow cells. You can enter up to 5 option legs to calculate the option strategy payoff.

Now, I logged into my STSUSA trial account and noticed an exit signal for BUD's short position. I have no opinion on this stock, I was only trading it to test out STSUSA's picking service, so I think I will do the same.

So, in summary, BUD started out trading at $50.20 a week ago. I sold a Put Backspread for $310 credit. A week later the stock is now trading at $49.64 and the option spread is trading at $250. My maximum possible loss on this trade can only by $190, so my return on investment is 31.58%.