Options are a fantastic investment to make money on the rise and fall of an asset. This is no surprise to anyone unless the first time you’ve ever heard of an option was in the preceding sentence. There are two kinds of options: calls and puts. Calls give traders the right to buy an asset at a specific price on or before a specific date; puts provide the right to sell an asset at a specific price on or before a specific date. When bought as a single contract, they offer unlimited reward with limited risk. Not bad, right? How would you like to reduce risk even further, while still keeping your appreciation potential high? Interested? Sure you are. Options spreads offer you a means to do just that.
Spreads composed of options with the same expiration date and different strike prices are known as vertical spreads. There are two types of vertical spreads: debit spread and credit spreads. Debit spreads include a bull call spread and a bear put spread—each one makes a profit in a bullish or bearish market respectively. Credit spreads include bull put spreads and bear call spreads. A bull call spread involves buying a lower strike call and selling a higher strike call against it. For example, if you wanted to create a bull call spread using XYZ Company’s stock trading at $31 per share, you could buy an XYZ March 30 call for $4.00 and sell an XYZ Mar 40 call for $2.00. Your net cost (maximum limited risk) is $2.00, or $200 per spread. This is the absolutely the most you can lose even if XYZ falls to a penny a share. This is because that for every dollar you make on the call you purchased, you lose a dollar on the one you sold. Your reward potential can be calculated as the difference in strike prices minus your net debit. Therefore your maximum reward is $800 ($10 - $2 = $8). Your reward to risk ratio is 4 to 1— you’re risking $2 to make $8. Would you place this trade if your prospects for XYZ were good? I certainly would! Trades like this exist every day if you’re willing to look for them and structure them on appropriate assets. You can often find trades with reward to risk ratios of much higher than that. I would not look at a spread with a reward to risk ratio of less than 3 to 1 unless the probability that the trade would materialize in my favor was extremely high.
In contrast, a bull put spread consists of buying a lower strike put and selling a higher strike put against it to create a net credit—the maximum profit available on the spread. The hope here is that the stock will continue to rise and your long put will be worth more than your short put.
As you can see, the ability to utilize either calls or puts doubles your chances of finding a great trade. Whether you use calls or puts, your overall outlook is bullish on the stock and I recommend that you look at both sides before making up your mind as there can often be a big difference between the reward to risk ratio between the calls and puts when placed as a spread. Placing the trade is as simple as calling your broker and telling him or her that you want to place a spread order to open a position and saying: “I want to place a spread order to open a position. “I want to buy the XYZ March 30-40 call spread at a net debit of $2.00.” Getting out of the trade is accomplished by calling up and telling him or her you want to close an existing position and saying: “I want to sell the XYZ March 30-40 call spread at a net credit of $8”
The opposite side of the market is the bear side! I am an eternal optimist, so I don’t place many bearish trades unless the prospects for the company are bleak at best. A bear put spread is a debit spread compromised of buying a higher put and selling a lower put against it. The bear call spread is a credit spread that consists of the purchase of a higher call and the simultaneous sale of a lower call. Placing the order is done the same way as in the bearish examples and the reward to risk ratio is figured the same way. The most important factor when trading spreads is the probability that the trade will move as you expect. With a low probability, it is not even tempting to take a trade with an extremely high reward to risk ratio.
A great advantage to spread trading is that you can utilize LEAP options which gives you a longer time frame in which to be right. This increases your probability that you will be
successful in the trade. Spreads cost less than the outright purchase of calls or puts and allow
you to more thoroughly diversify your holdings so that you don’t break the old rule about putting all your eggs in one basket.
A bull call spread is a debit spread created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. This strategy is best implemented in a moderately bullish market to provide high leverage over a limited range of stock prices. The profit on this strategy can increase by as much as 1 point for each 1-point increase in the price of the underlying asset. However, the total investment is usually far less than that required to purchase the stock. The strategy has both limited profit potential and limited downside risk.
Steps to Using a Bull Call Spread
- Look for a moderately bullish market where you anticipate a modest increase in the price of the underlying stock-not a large move
- Check to see if this stock has options
- Review call options premiums per expiration dates and strike prices
- Investigate implied volatility values to see if the options are overpriced or undervalued
- Explore past price trends and liquidity by reviewing price and volume charts over the last year
- Choose a lower strike call to buy and a higher strike call to sell with the same expiration date
- Calculate the maximum potential profit by multiplying the value per point by the difference in strike prices and subtracting the net debit paid
- Calculate the maximum potential risk by figuring out the net debit of the two option premiums
- Calculate the breakeven by adding the lower strike price to the net debit
- Create a risk profile for the trade to graphically determine the trade's feasibility
- Write down the trade in your trader's journal before placing the trade with your broker to minimize mistakes made in placing the order and to keep a record of the trade
- Contact your broker to buy and sell the chosen call options
- Watch the market closely as it fluctuates. The profit on this strategy is limited-a loss occurs if the underlying stock closes at or below the breakeven point
- To exit the trade, you need to sell the lower strike call and buy the higher strike call or simply let the options expire. The maximum profit occurs when the underlying stock rises above the short call strike price. If and when the short call is exercised by the assigned option holder, you can exercise the long call and deliver those shares to the option holder at the lower long call price, pocketing the difference plus the premium from the short call
Often the biggest problem newcomers to options trading face is choosing which strategy is the most appropriate to use under a given set of market conditions. It’s easy picking a stock strategy; you either buy or you sell. Stock prices are not affected by time and volatility. Since options have multidimensional attributes, the trader is faced with the same choice of buy or sell, but also needs to determine such things as volatility, time and delta. It seems that ever since we started trading sideways, everyone has picked “the bottom,” and are therefore attempting to trade bullish positions. This isn’t necessarily a bad thing; however, the rationale is disturbingly biased, particularly from the media heads.
One of the most important things a trader can do is forget about what the market might do and determine what it is doing. Then set up a play that will pose limited risk should you be wrong. So aside from experience, how do you determine what the market is telling you and how do you know what strategies to use? In order to avoid the risk of turning this into a discussion on technical analysis, I will only mention that there are plenty of technical and fundamental indicators that you can use to determine the trend. After you have determined the trend, you need to get some idea of the volatility of the market and the underlying stock you are going to trade. (Though you can get this from other sources, I must shamelessly plug our Platinum site as my personal favorite source for this data.) From there, you can determine what is the most appropriate strategy that has the highest probability of becoming profitable.
Of course, in order to keep from inundating yourself from information overload, it’s best to keep your strategies for each scenario to a minimum. As you progress as a trader, experiment with variations of the strategies, or new ones to accommodate your evolving personality. For example, in a bullish market with low volatility—although you can choose from a number of strategies—it might be best to practice with just bull call spreads until they become so boring that you’re making too much money (ha, never!). Then maybe start to experiment with ratio back spreads.
The following chart illustrates that indeed you can make money in any market. I’ve put together a matrix of one example of a strategy I would be using under each of the various market conditions. I suggest you do the same with the strategies you currently know and understand. If you come to an empty cell that you cannot think of a strategy for, that’s what you need to research. Keep the matrix at your side until you can trade your strategies cold. Keeping with the Edvesting methodology, all of the following are spreads of some kind. As the saying goes, better spread than dead!
You probably noticed that in more than half of the above strategies, I’ve entered whether the play should be out-of-the- money [OTM], at-the-money [ATM] or in-the- money [ITM]. Although these choices are only my opinion, the point is that I have determined what I believe to be strategies that take advantage of higher leverage with an appropriate balance of risk/reward.
Speaking of risk/reward, when you’ve determined the market and the strategy you wish to seek out, the next thing you want to determine is how much risk you would like to take on for each play. As an example, I won’t put on a credit spread for any less than $1 for every $5 difference between strikes. On debit spreads, I won’t even look at them unless the minimum reward potential is 200% return. That’s not to say that I have to make 200%; just that on a 10 point spread, I only have to put up a maximum of $3.30 to make the $6.70. This is the same for all other spreads. You should decide for yourself how much you are willing to risk for every debit spread, calendar spread, etc.