“What on Earth is a ‘Nested Spread Trade?’ “

We’ve been using the terms, “Income Method” and “Nested Spread Trade” to describe the TEN adjustments we might make to a married put position. These Nested Spread Trades are done to either:
1) take income out of the married put without necessarily selling the stock,
2) reduce the risk in an already hedged position; or
3) both of the above.
We make bold claims about ‘riskless’ spread trades as well. How on earth can a spread trade truly be riskless?  Is it really possible to take a credit but never have to worry about a credit spread going against you? The answer is yes, provided that you understand the context in which to play the said spread… and do it correctly.
Let’s take the example of a standard bear call spread. In a bear call spread, you sell a lower strike priced call and simultaneously buy an upper strike priced call. This generates a credit, but there is a dark side to this situation as well. Ya might have to pay back MORE than you took in.
The Bear Call Spread can pay a credit, but beware if the stock rises!
Here  we’re showing the sale of the June $57.50 call, coupled with the purchase of the June $60 call. This generates a $1.05 credit, (per share… that’s $105 total!) and that’s a happy thing. However, if the stock goes up to $60 or higher we’re gonna have a problem.
Because we’ve sold a $57.50 call, we’ve taken on the obligation to deliver 100 shares of SBUX at that price. If SBUX goes up that will mean a problem: we gotta buy SBUX at whatever price it’s trading at expiration… deliver it for $57.50… and eat the loss.
How on earth can a spread trade truly be riskless?  For example is it really possible to take a credit but never have to worry  about a credit spread doing against you? The answer is yes, provided that you understand the context in which to play it.”
Fortunately the $60 call we’ve purchased keeps us out of too much trouble … if SBUX happens to be trading at, say, $100 we aren’t in a pickle with a ‘naked’ call.  We can use the $60 call to pick up 100 shares at only $60, no matter what the open market wants for SBUX.
When we deliver those shares at $57.50 that we buy at $60, that’s a loss of $2.50 ($250 total), right?  But that $2.50 loss is lessened by the $1.05 credit  we took up front.  So the maximum possible loss on this spread trade is the difference of $1.45 ($145).
Whew.

You might have picked up $105, but may LOSE $145 instead!

“But wait,” you might be saying. “What was all this about a RISKLESS Spread Trade? Didn’t you say that a credit spread could be done that would take a credit but would not risk anything?”
Yup. I did. So, remember I said it would be a “NESTED” spread trade. Well, what do we ‘nest’ this Bear Call Spread in, in order to make it riskless?
The risky part about doing a Bear Call Spread play in the first place is that you don’t own the stock. That’s what creates all the concern in the first place.
Let’s review: Seling a call takes a credit, but leaves you open to the liability of perhaps having to deliver stock at a lower price than it’s currently trading. To satisfy that obligation, you’ve now got to go out and buy the stock. The upper strike call keeps you from getting into TOO much trouble for taking a credit… BUT!
Hey, doesn’t all this bruhaha about going and finding stock to deliver just go away… if you already OWN the STOCK?
Heh. Smile, young grasshopper. You’re beginning to see how ‘nesting’ might work.
Let’s look at another position with SBUX, a married put trade:  Here, I’m showing SBUX with a cost basis of $54.40, although right now it’s trading at $57.95 . Never mind about  the fact that  Starbucks is  currently priced  over three dollars higher  than the cost basis I’m showing; that’s  a topic for another post.
What I’m doing here is  showing a married put position that is that is completely neutral: the cost basis of the stock and the put  combined is exactly equal to the strike price of the put.
There is no  risk for this position anymore, but there are no guarantees of a gain either.  Take a look at the graph:

Stock plus put. When cost basis for stock is reduced, there may be zero risk; BULLETPROOF

We call this married put position  “Bulletproofed”  because the cost basis of both the stock and the put  is equal to  the right price of the put. So there’s no  risk left in it, but there’s also no guarantee  of a gain…  If  Starbucks stays below $60  all the way until expiration we end up with nothing.
SO now back to our Bear Call Spread, selling the June $57.50  call and simultaneously buying the June $60 call.  We’re going to generate a dollar and five cents credit, right?  Only now let’s do the  bear call spread in the context of the married put  position.
This changes everything. Because we have the stock on hand to deliver… there is no longer any risk to writing  a  call.  In fact,  when we  do a bear call spread it’s as though  we get paid to own the upper strike call.  Cool? Yeah,  REAL cool. Because before, we had a protected stock but no guarantees. NOW we have a protected stock and we’re going to get to keep over a hundred bucks no matter which way she goes. I’m going to enter all four legs into the PowerOptions Custom Spread Tool:
So we’re combining the married put, which insures  Starbucks  clear out ’til October…  with a near  expiration June  $57.50/$60  bear call spread. The result is a guaranteed  return of the $105  credit from the bear call spread. That’s retained…  whether  Starbucks goes up, down, or sideways.
Take a gander at this pretty graph  with all four legs in place:

Riskless Spread Trade

 

Unlimited Upside potential for the Married Put, guaranteed credit from the Bear Call Spread!
This is why I can claim that this bear call spread… which is properly ‘nested’ within a married put… has no risk. If we are called on to deliver the stock, it’s already on hand.
That totally neutralizes the risk posed by doing a bear call spread. The context of stock ownership is the secret to “Nested Spread Trades”.

Also, I’d love to offer you a free PDF that walks you through one (of SEVEN) types of riskless spread trades.

Click me! <== to get this free PDF.

Hey, did ya ‘like’ this post? Say so. Think I’m a total harebrain? Say that too. Bring on the comments, Traders! Glad to give ya some more brain candy. Tell me what you think and don’t be shy.
Happy Trading,
Kurt

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.