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A variety of options strategies can be employed to hedge risk and leverage capitalIntroducing Vertical Spreads Since all markets have the potential to fluctuate beyond their normal trend, it is essential to learn how to apply strategies that limit your losses to a manageable amount. A variety of options strategies can be employed to hedge risk and leverage capital. Each strategy has an optimal set of circumstances that will trigger its application in a particular market. Vertical spreads are basic limited risk strategies, and thats why I tend to introduce them first. These relatively simple hedging strategies enable traders to take advantage of the way option premiums change in relation to movement in the underlying asset. Vertical spreads offer limited potential profits as well as limited risks by combining long and short options with different strike prices and like expiration dates. The juxtaposition of long and short options results in a net debit or net credit. The net debit of a bull call spread and a bear put spread correlates to the maximum amount of money that can be lost on the trade. Welcome to the world of limited-risk trading! However, the net credit of a bull put spread and a bear call spread is the maximum potential reward of the positiona limited profit. Success in this kind of trading is a balancing act. You have to balance out the risk/reward ratio with the difference between the strikesthe greater the strike difference, the higher the risk. One of the keys to understanding these managed risk spreads comes from grasping the concepts of intrinsic value and time valuevariables that provide major contributions to the fluctuating price of an option. Although changes in the underlying asset of an option may be hard to forecast, there are a few constants that influence the values of options premiums. The following constants provide a few insights into why vertical spreads offer a healthy alternative to traditional bullish and bearish stock trading techniques: Time value continually evaporates as an option approaches expira tion. OTM and ATM options have no intrinsic valuethey are all time value and therefore lose more premium as expiration approaches than ITM options. The premiums of ITM options have minimum values that change at a slower pace than OTM and ATM options. Vertical spreads take advantage of the differing rates of change in the values of the options premiums. The four vertical spreads that we use can be broken down into two kinds of categories: debit and credit spreads, each with a bullish or bearish bias. The success of these strategies depends on being able to use options to exploit an anticipated directional move in a stock. As usual, timing is everything. To become good at forecasting the nature of a directional trend, try to keep track of a stocks support and resistance levels. Remember, a breakout beyond a stocks trading range can happen in either direction at any time. Limiting your risk is a great way to level the playing field. VERTICAL SPREAD MECHANICS Vertical spreads are excellent strategies for small investors who are getting their feet wet for the first time. Low risk makes these strategies inviting. Although they combine a short and a long option, the combined margin is usually far less than what it would cost to trade the underlying instrument. If you are new to the options game, take the time to learn these four strategies by paper trading them first. The rest of this chapter is designed to help you become familiar with these innovative strategies. There are two kinds of debit spreads: the bull call spread and the bear put spread. As their names announce, a bull call spread is placed in a bullish market using calls and a bear put spread is placed in a bearish market using puts. Debit spreads use options with more than 60 days until expiration. The maximum risk of a debit spread is limited to the net debit of the trade. In contrast, the maximum profit of a credit spread is limited to the net credit of the trade. There are two kinds of credit spreads: the bull put spread and the bear call spread. The bull put spread is placed in a bullish market using puts and a bear call spread is placed in a bearish market using calls. In general, credit spreads have lower commission costs than debit spreads because additional commissions are avoided by simply allowing the options to expire worthless. Since credit spreads offer a limited profit, make sure that the credit received is worth the risk before placing the trade. To determine which strategy is the most appropriate, it is important to scan a variety of strike prices and premiums to find the optimal risk-toreward ratio. This is accomplished by calculating the maximum risk, maximum reward, and breakeven of each potential spread to find the trade with the best probability of profitability. Choosing the type of trade (debit or credit) depends on whether you prefer to pay for a trade out-of-pocket or take the credit and ride the bear or bull all the way to expiration (see Table 5.1). BULL CALL SPREAD The bull call spread, also called the long call spread, is a debit strategy created by purchasing a lower strike call and selling a higher strike call with the same expiration dates. The shortest time left to expiration often provides the most leverage, but also provides less time to be right. This strategy is best implemented in a moderately bullish market. Over a limited range of stock prices, your 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 the amount required to buy the stock shares. The bull call strategy has both limited profit potential and limited downside risk. The maximum risk on a bull call spread is limited to the net debit of the options. To calculate the maximum profit, multiply the difference in the strike prices of the two options by 100 and then subtract the net debit. The maximum profit occurs when the underlying stock rises above the strike price of the short call causing it to be assigned and exercised. You can then exercise the long call, thereby purchasing the underlying stock at the lower strike price and delivering those shares to the option holder at the higher short price. The breakeven of a bull call spread is calculated by adding the net debit to the lower strike price. Choosing the Options In order to choose the options with the best probability of profitability for a debit spread, it is important to balance out four factors: 1. The options need at least 60 days until expiration in order to give the underlying stock enough time to move into a profitable position. 2. Keep the net debit as low as possible to make the trade worthwhile. 3. Make the difference in strikes large enough to handle the net debit so that the maximum profit is worthwhile. 4. Make sure the breakeven is within the trading range of the underlying shares. Bull Call Spread Mechanics With XYZ trading at $51, lets create an example by going long 1 XYZ September 50 Call @ 3.50 and short 1 XYZ September 55 Call @ 1.50. The difference between the premium for the long 50 call and the credit received from the short 55 call leaves a net debit of 2 points. The maximum risk for this trade is the debit paid for the spread, or $200: (3.50 - 1.50) 100 = $200. The maximum reward for the trade is calculated by subtracting the debit paid from the differences in the strike: [(55 - 50) - 2] 100 = $300. The breakeven on this strategy occurs when the underlying assets price equals the lower strike plus the net debit. In this case, the net debit is 2 points, so the breakeven is 52: (50 + 2 = 52). Thus, the trade makes money (theoretically) as long as the underlying asset closes above 52 by expiration. The risk profile for this trade is shown in Figure 5.1. The risk profile for a bull call spread visually reveals the strategys limited risk and profit parameters. Notice how the maximum profit occurs at the short call strike price. To find a market that is appropriate for placing a bull call spread, look for any markets that are trending up nicely or have reached their support level and are poised for a rebound. Your intention is for the market to rise as high as the strike price of the short call. That way, if the short call is exercised early, you can make the maximum return on the trade by exercising the long call and pocketing the difference. Exiting the Position To exit a bull call spread, it is important to monitor the daily price movement of the underlying stock and the fluctuating options premiums. Lets explore what happens to the trade in the following scenarios: XYZ rises above the short strike (55): The short call is assigned and you are obligated to deliver 100 shares of XYZ to the option holder at $55 a share. By exercising the long call, you can buy 100 shares of XYZ at $50 a share and pocket the difference of $500 (not including commissions). By subtracting the cost of the trade ($200), the net profit on the spread is $300the maximum profit available. XYZ rises above the breakeven (52), but not as high as the short strike (55): Offset the options by selling a 50 call at a profit and buying a 55 call back at a slight loss, pocketing a small profit. XYZ remains below the breakeven (52), but above the long strike (50): Sell a 50 call at a profit and buy a 55 call at a loss, pocketing a small profit; or wait until expiration and sell the long call at a slight profit to offset the trades net debit and let the short option expire worthless. XYZ falls below the long strike (50): Let the options expire worth less, or sell a 50 call prior to expiration to mitigate some of the loss. Bull Call Spread Strategy: Buy a call at a lower strike price. Sell a call at a higher strike price. Both options must have identical expiration dates. Market Opportunity: Look for a moderately bullish to bullish market where you expect an increase in the price of the underlying asset above the price of the call option sold. Maximum Risk: Limited to the net debit paid for the spread. Maximum risk results when the market closes at or below the strike price of the long call. Maximum Profit: Limited. (Difference in strike prices - net debit paid) 100. Profit results when the market closes above the breakeven. Breakeven: Strike price of lower call + net debit paid. Margin: Required. Amount subject to brokers discretion. |
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