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Martin Noël

July 26, 2017

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6 minutes read

As shown in the following graph, shares in the Canadian National Railway Company (CNR) have begun a slight correction since peaking at $108.64 at the end of June. When the markets closed on July 24, CNR was trading at $101.63 and was near its 34-week moving average (34-WMA), which has served as a support point several times in the past.

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This article presents a strategy for an investor who believes that the price of CNR may rise between now and December 2017, comparing the implementation of a bull spread with that of a reverse butterfly spread. This will allow the investor to profit from a meltdown, should one occur.

 

Implementing a Bull Put Spread

 

Profit and Loss Diagram on Expiration of the Bull Put Spread

The bull put spread is established by writing the put option contract CNR 171215 P 100.00 at $3.50, for a credit of $350 per contract, and purchasing the put option contract CNR 171215 P 95.00 at $0.85, for a debit of $85 per contract. This gives a total credit per contract $265, which is also the maximum potential profit if CNR closes at a price equal to or above $100 when the options expire on December 15, 2017. The $735 loss is calculated by taking the difference between the two strike prices ($100 – $90), or $10 per share, less the credit of $2.65 per share. This gives $7.35 per share, multiplied by 100 shares per contract. The investor will incur this loss if CNR closes at a price equal to or less than $90 when the options expire on December 15, 2017. The position will be profitable if the price of CNR is above the breakeven price of $97.35 and will yield a loss if the stock closes at less than this price.

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Implementing the Bull Put Spread
As part of any analysis, we should consider the possibility that our scenario will not play out as expected. In this instance, the price of CNR could continue to fall, and the bull put spread could result is a $735 loss if it closes under the option’s $90 strike. To reduce this loss, we can implement a bear put spread that will generate a profit if the stock drops below $90.

 

Profit and Loss Diagram on Expiration of the Bear Put Spread

The bear put spread is implemented by purchasing the put contract CNR 171215 P 90.00 at $0.85 for a debit of $85 per contract, and by writing a put option contract CNR 171215 P 80.00 at $0.15 for a credit of $15 per contract. This results in a total debit of $70 per contract, which is also the maximum potential loss if CNR closes at a price equal to or above $90 when the option expires on December 15, 2017. The $930 profit is calculated by taking the difference between the two strikes ($90 – $80), or $10 per share, less the debit of $0.70 per share, for $9.30 per share multiplied by 100 shares per contract. This profit will be collected if CNR closes at a price less than or equal to $80 when the option expires on December 15, 2017. The position will also be profitable if CNR closes below the breakeven price of $89.30, but it will yield a loss if CNR closes above this price.

 

Metamorphosis: Turning a Bull Spread Into a Reverse Butterfly Spread With Put Options

Combining these two strategies gives us a profit and loss diagram known as a reverse butterfly spread with options, so adding a bear spread completes the metamorphosis from a bull spread into a reverse butterfly spread with put options.

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Profit and Loss Diagram: The Reverse Butterfly Spread With Put Options

As you can see, the resulting reverse butterfly spread allows us to profit from an increase in the price of CNR, which was our initial objective, but also to profit from a drop if the correction continues and the price falls to under $90 by expiration on December 15, 2017. We added this potential for a reasonable cost of $70 per contract (the total debit of the bear spread). Consequently, our maximum loss goes from $735 to $805, and it is realized only if CNR closes exactly on the strike of $90 when the options expire on December 15, 2017. On the other hand, our maximum profit is reduced by $70, from our initial $265 to $195. However, the maximum profit may be obtained if CNR closes at above $100 or below $80, our two strikes. Lastly, the position will generate a loss if CNR closes between our two breakeven prices of $81.95 and $98.05.

 

Good luck with your trading, and have a good week!

 

The strategies presented in this blog are for information and training purposes only, and should not be interpreted as recommendations to buy or sell any security. As always, you should ensure that you are comfortable with the proposed scenarios and ready to assume all the risks before implementing an option strategy.



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