July 17, 2009 - GOOG Put Spread (Post Analysis)

This entry serves as the after-game analysis of the trade I put in on July 3rd on a Google Put Spread strategy.

In after hours yesterday Google came out with their Q2 earnings results, reporting 3% revenue increases from the same quarter last year. The news wasn't taken well by the street and the stock closed about 3% lower at $430.25 which is way above the threshold for our options. As of today's close, our short positions in the 350s expires unexercised and we keep the income of $300 / base contract. Similarly our long position in the 360s expires worthless and we lose $175 for a net of $125 per base contract.

Note that the example is in base contracts. To increase profits (and also exposure), you increase the number of contracts, but it is very important to keep the 1:3 ratio of long to short for an effective spread.


I've gotten a lot of questions about why I would buy the 360 puts, while selling the 350s and not just sell the 350s if I thought Google would stay above 350. It is true that selling only the 350s alone would create more profits, but it would also create more risk. With giving up some of the profits upfront you can hedge your position in two ways:

1. Price:
If the earnings report was horrible and the stock tanked you would still be protected until the breakeven point at around $345. And even below that your losses would be partially offeset by the gain in the 360 puts you were holding.

2. Volatility:
Volatility can increase option pricing drastically. If the stock fluctuates with wild swings volatility will increase and so will the price of your options. If the volatility is accompanied by a drop in price then the put values may increase drastically. Just to give a sense of the change, if the price drops to $370 in a volatile market, your short options (which were sold for $1/share) can increase to $10/share. This creates a temporary loss 10 times your original premium. If you have sold a lot of contracts this can cause a large loss to your portfolio and increase your margin requirements (you need more money in your account to hold this position until expiry).

However, with your hedge in place, the increase in the price of the 360 put will offset some of the losses and take wild swings in profit and loss out of your portfolio.

Hedge funds are actually measured based on how volatile their portfolio is compared to market volatility.... does it swing wildly? or is it stable!

Stability and protection is worth giving up some profits.... especially in this market.