My Favorite SOS – ITM* Put Back Spread for Credit Was Once One Guru’s Favorite Trade....

By Charles Cottle

It was a while back but a ‘still’ famous Options Seminar Guru (Ex-Real Estate Seminar Guru) used to tout ITM* put back spreads for credits.  One of his students sent me one of the expensive videos where the guru stated that this was his favorite strategy.  That was until the student told him what he learned.  The video later was deleted from the product line.

Attractive ITM* put back spread criteria:
1) A stock that can really move
2) Overall implied volatility levels are reasonably low
3) The spread can be executed for a credit.
4) The options to sell have greater implied volatility than the ones being bought.
MMM met all the criteria and was trading at $76.20

The NOV 85/80 Put (+2*80P by -1*85P) back spread for a credit of about .45 or so by paying 4.20 for each 80 put, twice and receiving 8.85 for the 85 put, once.  The following image uses Position Dissection to uncover the ‘Hidden Reality’.  The position, as it turns out, is no essentially a cheap call bull spread and an ITM* put.

So what’s the problem?

Ask yourself (look at the synthetic dissected position in red):

1) Would I buy an ITM* put for 4.20 and an OTM call vertical for .35 as a spread? 

Not many traders would because there are better ways to get short.  The vertical would not protect the upside loss until MMM got above 84 or so – a very impotent hedge.

2) Would I buy an OTM* 80/85 call vertical for .35 when the naked 80 call is only .40? 

Not many traders would because for .05 more, why have the hindrance of the short eating into the performance of the long?  You normally prefer a vertical when the sale option provides a reasonably discounted price for the play.

3) Would I sell an OTM* 85 call at .05?   Synthetically, that is what is being achieved on the vertical and the actual proceeds net of commissions.

Not many traders would because the 85 call is too cheap to be short and there is the added pain if you ever needed to buy it back.

4) OK, forget about the 85 call.  Would I buy an 80 Straddle when the put is 10 times greater and stronger than the call?

Not many traders would because it is severely unbalanced and in a normal up-move, the call will not make as much or more than the put would lose.

5) OK, forget about the 80 call, also.  That leaves just a long 80 put.  Would I simply buy the 80 put? 

You might but you would have to be bearish.  Wait a minute.  Who said anything about being bearish? 

BTW: The spread is synthetically a 4.55 debit (80 straddle price minus 85 call price) which is the most one could lose if the stock settled at 80.00 on expiration day.

*ITM stands for ‘in-the-money’ and OTM stands for ‘out-of-the-money’.