I bought 3 Feb 2010 $34 puts on ANF for $5.60 and sold 3 Feb 2010 $27 puts on the same stock for $2.16.
This means I paid $5.60 for the right to sell ANF at $34 any time between now and February of next year. I also was paid $2.16 for my promise to buy ANF for $27 in the same time frame. The stock was trading at around $31 when I made the trade. This is a more complicated option trade, and has several possible outcomes.
If, in Feb 2010, ANF is trading above $34 a share, the puts I purchased are worthless. Why would I sell it at $34 when it's on the open market for $35?
Loss: $5.60 - $2.16 = $3.44 per share, or a loss of $1,032 for my three contracts.
If ANF is trading at or below $27, I will be obligated to buy the stock at $27. I will also have the right to sell it at $34. I will buy the stock at $27 and sell it at $34.
Gain: $34 - $27 - $5.60 + $2.16 = $3.56 per share, or a gain of $1,068.
The complicated part comes if ANF is between these two strike prices; that is, if it's trading between my $34 sell price and my $27 buy price.
If it's trading at $33, I still have the right to sell it at $34--and I would do so. However, because of the $3.44 I paid to buy the put, that would not give me a profit on the position. The loss would be:
Loss: $34 - $33 - $5.60 + $2.16 = $2.44 per share, or $732 on the whole position.
So you can see, the lower the share price, the smaller my loss. This ticks over into profit if the share price is below $30.56 ($34 - $3.44):
Break-even: $34 - x - $5.60 + $2.16 = $0 (and solve for x. 4th grade algebra has been more useful than my math minor).
So if ANF is below $30.56 by the February expiration date, I make a profit on the position, which increases the lower the price goes. The limit to my profit comes when I reach my lower strike price of $27. At that point, profit stays constant at $3.56 per share. The limit to my loss comes at my higher strike price of $34. At that point, my loss is $3.44 per share. If the price is somewhere in between, my profit/loss varies between those two limits.
Okay, on to the hypotheticals. I do not need to wait until expiration to change this situation. As the price of the underlying stock decreases, the puts I bought will become more valuable; it's more attractive to sell a stock for $10 over market price than for $5 over asking price. ANF has dropped by $1 per share since I made this trade, so the same puts I bought for $5.60 are now trading for $6.00. You can sell options just like you can sell stocks. Right now, I could sell the option I bought for more than I paid for it (but not enough more to make it worth the trade). Likewise, the puts I sold have decreased in value; it is less attractive to buy a stock for $5 below market price than for $10 below market.
Both options will decrease in value as they approach expiration; options are hedges against uncertainty, and the future 6 months from now is more uncertain than next month. So, I may close one or both of these positions early if I can do so profitably.
I also didn't need to do a one-for-one sale or purchase of these options. I could have bought just one put, for a net cost of $560, and still sold three puts, for a net gain of $648. Then, the cost of the puts I bought would be completely covered by the income from the puts I sold. This would change my profit/loss outlook.
That is, if ANF is trading above $34, the puts I'd bought expire worthless. However, I still made (300 * $2.16) - (100 * $5.60) = $648 - $560 = $88 on the trade.
If ANF is at or below $27, I'm obligated to buy 300 shares at $27, but can sell only 100 shares for $34. So, I would have paid $8100 for all three hundred shares. I'd be able to sell 100 shares for a total of $3400. I would be left with two hundred shares at a net cost to me of $4700; that's $23.50 per share. If ANF is trading at $23.50, I can sell the shares for a profit/loss of zero. If it's trading above $23.50 I can sell them for a profit. If it's trading below $23.50, I could sell at a loss.
So you can see how you can mix and match options to suit your purposes. This can get very complicated, and it's easy to overlook something and open yourself up to risks you weren't expecting. I like writing out the outcomes of each possibility ("if p happens, the effect on my trade is q"), especially when I'm learning a new option strategy
