We will use a Broken Spread when a stock has moved against us with strong momentum. This would be caused by a major news event, significant change in the Market, or fundamental shift in the company's direction. Let's take a look at an example of a Broken Spread from October of 2006.

In this case, we entered our original Bear Call Spread with the mindset that it could easily turn into a Broken Spread. We enjoy using this strategy on Google when its earnings release date falls at the end of the options cycle. If done correctly, this can result in a big profit.

We started by entering an October 440-450 Bear Call Spread on Google. At the time, the stock was sitting below $400.

After we entered the spread, Google proceeded to make a significant run-up before earnings. The stock broke through previous areas of resistance along with its 50-day moving average (red line) and 200-day moving average (black line). Then it started pressuring our $440 strike price.

One thing to note on this spread is that Google's earnings release was the last day of the October option's cycle. The day before this, we had several indications showing a high probability that the stock was going to move higher. Based on this and the recent move up in the stock price, we made the following adjustments.

We bought back the 10 October Calls at the $440 strike price (we previously sold them in our Call Spread). At this point we were still long our 10 October Calls at the $450 strike price. However, the cost of buying back the $440 calls caused us to take a loss in this spread. Due to this, we placed an October Bull Put Spread on Google. We sold 10 October Puts at the $390 strike price and bought 10 October Puts at the $380 strike price. This enabled us to maintain this position for nearly breakeven. Normally, entering a spread this late in the cycle would not work. In this case, the earnings announcement helped inflate the prices in the options. This allowed us to take in a good size credit on the new put spread.

After doing these adjustments to our original spread, as long as the stock stays above our 390-380 Bull Put Spread, we will finish close to breakeven on the trade. However, if we get a big move upward, then we profit. The size of the profit depends on how far in-the-money the stock moves (because we are long 10 October Calls at $450 strike price). Keep in mind that the company releases its earnings the night before the third Friday in the month (options expiration date).

The next morning, the stock gaps above our $450 strike price and we sell our calls. After the close, our put spread expires worthless. On this trade, we made a $9,000.00 profit. This helps demonstrate the importance of position management and making adjustments once you are in a spread.