Anatomy of an RPM Part II: Taking Back the Market Maker’s Edge

In the last post I showed you the beginning of HUM, an RPM (RadioActive Profit Machine) that I sent out to Subscribers to my Fission’ service last March.

HUM is now Bulletproof, meaning that the cost basis for the stock AND put option is below the strike price of the put. In short, a position with unlimited potential to gain but no longer having the ability to go against.

This sweet situation… and how to GET there… is what I’m documenting with these Anatomy of a RadioActive Profit Machine posts. Past performance is no guarantee of future results.

All righty then… so once we have a stock and long, long term put in place protecting it, this construct is only the beginning point. Now we want to look for an EDGE to ‘put’ into our married put. This edge comes in the form of one or more of the ten so-called  ‘Income Methods’… adjustments made to the position to reduce the net cost basis, take a credit, or both.

Today’s adjustment comes courtesy of Probability of Success, as they have asked me to be a guest speaker at an upcoming event July 9. Let’s take a gander at Income Method #6: Selling a Bear Call Spread.

The Money (AHEM) The MARKET Maker’s Edge Against You

Whenever you buy or sell stocks or options, there is only one point contact that everyone eventually runs into. Whether you are a retail trader, broker, whatever… at one point or another you must deal with the Market Maker. His weapon of choice: the Bid/Ask spread.

Let’s talk about the example from last post, HUM:

March 11. 2011 Humana RPM (RadioActive Profit Machine)
HUM  shares                $63.90
Aug 2011 $65 put       +$  5.80
Total Invested               $69.70
Guaranteed Exit          -$65.00
Total Amount AT RISK  $ 4.70
…or 6.7%

Hey, ever go to an old-fashioned melodrama? Or maybe something more recent in tradition like The Rocky Horror Picture Show? It’s an audience participation thing. Whenever you hear the hero mentioned it’s “Hooray!” …but when the villain comes on the scene we try to boo him off the stage.

“Castles don’t have phones…” Ahem. Okay, where were we?

Ah yes, HUM married put position. In order to buy this position above, it takes $63.90 to buy the stock. But the Market Maker (boo! hiss!) may only pay $63.85 if you wanted to SELL the stock. The Bid/Ask spread in this instance would be .05 cents, which the Market Maker (boo! hiss!) takes every time he turns over inventory.

Also, the put is $5.80 to buy, sure… but if you were a put SELLER you would end up only getting $5.60 from the Market Maker (boo!) In this case the spread is .20 cents.

SO… Our hero (hooray!) dares to take a position in this crazy market, hoping against hope for the stock to move in the right direction… which in this case is up. But the ‘deck’ is already stacked against him (poor hero!) to the tune of .25 cents on the purchase.

If the stock moves down, he not only loses on the absolute movement of the stock itself… he also loses a little bit extra when he sells to close the position. Who picks up his money? (boo!) That’s right. The Market Maker with his insidious Bid/Ask spread.

Let’s beat the Market Maker (yes! let’s!) and help the hero come out ahead (yayy!)

Let’s try the setup above with 200 shares and 2 put options. Here’s how the graph looks:

Humana Resources, 200 Shares protected by 2 Put Options

In the above graph and summary it’s easy to see that for an investment of $13,940 our hero (yayy!) has an instrument that has unlimited upside but only $940 AT RISK. That $940 divided by the $13,940 required for the position means that only 6.7% is AT RISK.

Of course, our valiant hero must buy both the stock and the put from the dreaded Market Maker (boo!) and  climb his way to the top. He loses .25 cents on the Bid/Ask spread when he buys, and may lose even more when he sells if his position runs against him (boo! boooo!)

But wait! What is that on the horizon? Could it be? Yes! It’s a RadioActive Trading Income Method (ta-daaa!) Income Method #6 to be exact… Selling a Bear Call Spread.

By selling two April $67.50 calls for .95 cents, and buying the April $70 calls for .45 cents, our hero (hooray!) picks up .50 cents credit. Here’s how that looks:

The Bear Call Spread takes a dollar credit, but may lose four dollars 🙁

Of course, by picking up a dollar (from two spreads at .50 cent credit apiece) our hero (yay!) is RISKING assignment. That means that if HUM happens to go up, he has to deliver on his promise to sell HUM at $67.50, regardless of how high it has gone.

What happens if HUM goes to $80 a share?
What this NORMALLY means is that our hero has to exercise his right to BUY 200 shares at $70.00, then deliver them at $67.50, causing a $500 debit. SInce he collected $100 on the front end, this means a loss of the total AT RISK amount of $400 in this spread.
It seems hopeless (oh, no!) because in one position, out hero has $940 AT RISK (gasp) and in another position he has $400 AT RISK (gaaasp) and to close these positions he must again deal with the dreaded Market Maker (boo!)
Okay, okay, enough with the melodrama already. But what I’m getting ready to spell out here is that our hero has used an Income Method… a ‘Nested Credit Spread’… to remove SOME of the risk from the married put, and ALL of the risk from the Bear Call Credit Spread.
Because the spread is being done within the context of owning the stock… there is no assignment risk needing to be offset by the long calls. Shoot, we’ve GOT the stock on hand!

For the Spread to be assigned, Stock has to gain

So rather than using the long calls to ‘cover’ our behinds, we’ll use them for profit.
With HUM at $80, the stock gets delivered at $67.50, yes, but long calls are worth $10 apiece.
The puts, being far out in time, will still be worth SOMEthing… and the whole position can be closed at a profit if HUM moves up.
You may notice that instead of a risk of $940, or 6.7% for the married put…
The addition of a near-expiry Bear Call Spread makes the risk $840, or 6.1%.
Don’t look now, but we’ve TAKEN the Market Maker’s edge away from him (HOORAY!) As the near-expiry Bear Call Spread expires in April, the credit received offsets the Bid/Ask Spread on both the buy and sell sides. And there is still time left ’til August when the put option expires.
Do you like how we took a credit from a Bear Call Spread, but if the spread goes against we still make money? Heh… gotta love it. In the next Anatomy of a RadioActive Profit Machine post I’ll show what happened next.
‘Like’ this post? LOVE it? Or have questions? Leave it all below! Until next time,
Happy Trading!

About Kurt Frankenberg

Kurt Frankenberg is an author and speaker about entrepreneurship, martial arts, and trading the stock and options markets. One of several "Biznesses" he founded as a teen, The Freedom School of Martial Arts, has been in continuous operation since 1986. Kurt lives in Colorado Springs with his wife Sabrina, German Shepherd Jovi, and his ninja cat Tabi.