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September 20, 2012

Bull Call Spread vs. Purchasing a Call on AAPL

Bull Call Spread vs. Purchasing a Call

Let’s say that you have a moderately bullish bias toward a stock and the overall market is slightly bullish. Is there a way that you can take advantage of this investing scenario while limiting risk? Certainly, there are a few. One that is often superior to the rest is the bull call spread. To learn to trade more option strategies, please visit our website.

Definition

When executing a bull call, you purchase call options at one strike and sell the same number of calls on the same company at a higher strike with the same expiration date. Let’s use Apple Inc. (AAPL) which is currently trading around $700 as an example. In this case you would purchase October calls at the 700 at-the-money strike at the ask price of $20. You would then sell the same number of October calls with a higher strike price, in this case 720 at the bid, $11.

The Math

Your maximum profit in the bull call spread is limited, you can make as much as the difference between the strike prices less the net debit paid. For simplicity, let’s assume that you purchased one October 700 call and sold one October 720 call resulting in a net debit of $9 (that’s $20 – $11). The difference in the strike prices is $20 (720 – 700). You, therefore, subtract 9 from 20 to end up with a maximum profit of $11 per contract. So, if you traded 10 contracts, you could make $11,000.

Although you limited your upside, you also limited the downside to the net debit of $9 per contract. To simply breakeven, the stock would have to trade at $709 (the strike price of the purchased call (700) plus net debit ($9)).

Advantage versus Purchasing a Call

When trading the long call, your downside is limited to the net premium paid. If you simply purchased the at-the-money October 700 call you would have paid 20. The potential loss is, therefore, greater when employing a call-buying strategy. If you move to a call with a longer time frame to expiration, you would pay even more for the option. This would also increase your potential loss per option.

Conclusion

By implementing a bull call spread, you have hedged your bets – limiting the potential loss. This is the advantage when comparing to purchasing a call outright. Remember that there are no fool-proof ways to make money by using options. However, knowing your strategy is a good way to limit losses.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 13, 2012

To Buy Puts or Not to Buy Puts…

Filed under: Uncategorized — Tags: , , , , , — Dan Passarelli @ 10:36 am

A lot of traders especially those who are just learning to trade options are enamored by the all mighty put – especially buying the shortest-term, or front month, put for protection. The problem, however, is that there is a flaw to the reasoning and practice of purchasing front-month puts as protection. Ah, yes; it’s true. Front-month contracts have a higher theta – and relying on front-month puts to protect a straight stock purchase is not, necessarily, the best way to protect an investment. If you were to continually purchase front-month puts as protection, that can end up being a rather expensive way to by insurance.

Although front month options are often cheaper, they are not always your best bet. The reasoning may be sound, the trader purchases a number of shares of the stock and purchases out-of-the-money puts to protect his position; but sound reasoning does not always lead to good practice. Let’s take a look at an example.

We will use a hypothetical trade today. The stock is trading a slightly above 13 and our hypothetical trader wants to own the stock because he/she thinks the stock will report blow-out earnings in each of the next two quarters. This investment will take at least six months, as the trader wants to allow the news events to push the stock higher.

Being a savvy options trader, our stock trader wants some insurance against a potential drop in the stock. The trader decides to buy a slightly out-of-the-money July 13 put, which carries an ask price of $0.50 (rounded for simplicity purposes). That 0.50 premium represents almost 4 percent of the current stock price. In fact, if the investor rolled option month after month, it would put a big dent in the initial investment. To be sure, after about seven months (assuming the stock hangs around $13) the trader would lose more than 25 percent on the $13 investment.

What if the stock drops? That is the ultimate rationale for the strategy in the first place: protection. The put provides a hedge. The value of the option will increase as the stock drops, which counterbalances the loss suffered as the stock drops. Buying the put is a hedge, a veritable insurance policy – though, albeit, an expensive one. Investors can usually find better ways to protect a stock.

Learn a better way to hedge with this FREE options report.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring

September 6, 2012

Butterflies and Weekly Options

The weekly options have been the topic of our blog many times before. Despite this topic being the trendy subject and in the forefront of many discussions, it is helpful to recognize the functional flexibility this dramatically shortened lifespan brings to a variety of option strategies. If you need to find out more about weekly options or other option strategies, feel free to visit the options education section on our website.

As an example, consider the case of a frequently traded spread vehicle, the butterfly. For those first encountering this strategy, it is helpful to consider briefly its components. It is constructed by establishing both a credit and a debit spread sharing a central strike price. It can be constructed in either all puts or all calls.

Butterflies can be designed to be either a non-directional or directional trade strategy. Functional characteristics include: negative vega, variable delta and accelerating gamma and theta during its life span. In the case of the long standing monthly duration option cycles which had heretofore been available, these characteristics developed over weeks to months and reached their final expression during the week of option expiration.

These functional characteristics have limited the utility of butterflies over brief duration moves occurring early in the options cycle. Many butterfly traders have had the experience of correctly predicting price action early in the cycle only to have the butterfly deliver little, if any, profit.

The short nine day duration of the weekly options has dramatically accelerated the pace of butterfly trading as the changes begin to occur literally over the extent of a few hours. As such, it is possible to gain the advantage of this trade structure over brief directional moves or in the case of non-directional traders to have market exposure for briefer periods of time.

John Kmiecik

Senior Options Instructor

Market Taker Mentoring