Rookies Stuff 02

In Rookies Stuff 01 I pointed out how difficult it is to buy options and then hope the underlying stock price moves (far enough) in the correct direction (up for calls and down for puts) quickly enough (before the options expire) to earn a profit.

Knowing that buying options is the favorite strategy for the vast majority of new option traders, I don’t want to leave anyone without an alternative strategy. For traders who do want to base trades on their ability to predict the future of stock market prices, there is the vertical spread strategy.

Very important point

Consider the two ideas below as something that the very new option trader should learn. It is far better than the strategy of buying puts or calls. However, this is just the entry point for using vertical spreads, These spreads can be used far more effectively by adding a bit of sophistication. Lessons on just how to do that follow in this series. For today, the key takeaway is that spread trading reduces risk (yes, it also reduces potential profits).

Note: A ‘spread’ is a hedged (reduced risk) position. There are many examples, but for our purposes today, the two strategies under consideration are

  • Buy a call spread when bullish
  • Buy a put spread when bearish

When we ‘buy’ a spread, we own the more expensive option and sell the less expensive. As a result, we pay cash to own the position.

Example:

    XYZ is $75 per share

    One possible bullish play is to buy a call spread:

    Buy XYZ Feb 21 ’14 75 calls and sell an equal number of XYZ Feb 21 ’14 80 calls. These trades are made simultaneously by entering a ‘spread order’ with your broker.

The options expire after the close of business on Feb 21, 2014.

The option strike prices are $75 and $80 respectively. In other words, those are the prices that the option owner has the right to pay for 100 shares – if and when that person decides to exercise those rights.

Buying the 75 call gives you the right to buy 100 shares of XYZ at $75 per share.
Selling the 80 call gives you an obligation. You may (or may not, depending on the price of XYZ when expiration arrives) be required to sell 100 shares of XYZ at $80 per share.

Important: There is no reason to fear the obligation to sell shares, even if you entered into this trade without owning any shares. Why? If the stock is above $80 per share and you are forced to sell those 100 shares at $80 per share, then the stock will (obviously) also be above $75 per share so that you can exercise your rights as the option owner to buy those shares at $75. When the smoke clears, you will have bought 100 share at $75 and sold 100 shares at $80, locking in a profit. You would have no remaining position.

This is a bullish position because the spread you bought gains value as the price of the underlying stock rallies.

An example of a bearish trade is to buy a put spread.

Example:

    XYZ is $75 per share
    Buy XYZ Feb 21 ’14 75 puts and sell an equal number of XYZ Feb 21 ’14 70 puts. These trades are made simultaneously by entering a ‘spread order’ with your broker. We are buying the put spread because the $75 put is more valuable than the $70 put. When we buy the more valuable option, we are buying the spread and paying cash.

It the stock moves below $75 per share, then both options gain value. However, the put with the higher strike price gains value more quickly. That means that the spread increases in value and you earn money if the stock declines, as hoped.

If the price is below $70 when expiration arrives, both options are ITM and the spread reaches its maximum value ($500). This is a bearish position because it earns a profit as the stock price falls.

Buying the 75 put gives you the right to sell 100 shares of XYZ at $75 per share.
Selling the 70 put may obligate you to buy 100 shares of XYZ at $70 per share. This obligation will go away if XYZ is higher than $70 when expiration arrives.

There is a lot more to learn about trading spreads. We barely touched the surface. Stay tuned.

*****

The classic 2002 options book on covered call writing is now available as both an ebook ($3.99) or paperback ($7.77, or less).
ShortBookOnOptions

http://goo.gl/8QUIK0

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