Options Trading

Options Spreads

If you find yourself thinking "how can I ever understand or remember this?" keep in mind that it doesn't matter how many options strategies there are, there are only two basic types of options: Calls and Puts. A spread trade is a variation that involves the buying and selling of options simultaneously on the same underlying.

There are specific advantages to spread trades, each strategy having a specific application. In general, spread strategies should be used when the outlook for a particular stock is neutral to slightly bullish or neutral to slightly bearish. The key word to remember here is "neutral." Spreads can be a great way to make money when you think a stock will remain in a fairly narrow trading range. However, since most spread strategies involve both Calls and Puts, you tend to limit your profits if a stock moves quickly in one direction or the other.

A particularly bullish outlook on a given stock is best served when you buy a Call option rather than play a spread, with which you'd likely dilute your gains with an incremental loss on the wrong side of the spread. Of course, the same is true when you're very bearish on a particular stock.

Bull Call Spread

Picking up from our strategy discussions in Section Four, the next type of spread trade we'll discuss is a Bull Call Spread. This is a debit-type spread, as opposed to the credit-type spreads we have discussed to this point.

Background:

The application for this type of trade is similar to a Bull Put Spread in that you are essentially neutral to bullish on the stock. The difference is in the type of option you will employ in the spread. What's important is that you expect the stock to close above the strike price that you sell.

The Bull Call Spread can be a great strategy to employ when you find that the premium for the Call options are undervalued, and it tends to work especially well when you don't have enough cash in your account to purchase enough shares for a potentially profitable position with a covered Call.

Case Study:

Here's how it works: as with previous examples, we'll assume that you have Level 3 trading authority from your broker. One other thing: the figures used in the following example were drawn from the options chain figures for an actual stock at the time this material was written, in case you were wondering where this information was generated.

Let's suppose you find a stock trading near $26.00 and are considering writing a Covered Call on the stock. You notice you do not have enough cash in your account to buy enough shares to make the trade profitable, so you enter into a Bull Call Spread instead.
With the stock trading for $26.00, you buy the Call option two strike prices below the current price of the stock, with the August $22.50 Calls at $3.75. This gives you the right to buy the stock for $22.50 per share.

Next you sell the August $25.00 Calls for $2.00. This gives you the obligation to sell the stock for $25.00 per share in the event the stock rises above $25.00 per share.

After spending the $375 per contract to buy the $22.50 Calls and collecting the $2.00 per share for the $25 strike price options you sold, the total debit from your account is $1.75 per share. This is now your maximum potential loss on the trade.

Maximum Profit:

Your maximum profit for this transaction is $0.75 per share. This maximum will be achieved if the stock closes above the $25 strike price that you sold on expiration Friday.

Here's how the trade results in your maximum profit:

If the stock closes above the $25.00 Call option you sold, the Options Clearing Corporation will go into your account on Saturday following the third Friday of the month to purchase the stock for $25.00. When they see that you do not own the stock, they will automatically exercise the August $22.50 Calls and buy the stock for $22.50 and sell it for $25.00.

Your account will then show you bought the stock for $22.50 and sold it for $25.00 for a $2.50 gain. The trade cost you $1.75 to enter into so your total profits now come to $0.75 per share.

A side note: You are not required to have the funds in your account to purchase the stock for $22.50 since you will immediately sell it for $25.00.Your original transactions resulted in a net debit to your account of $1.75 per share. The difference between the original debit and the credit you receive upon the sale of your stock is the maximum profit of $0.75 per share, or $75 per contract.

Maximum Loss:

You bought the August $22.50 Calls for $375 per contract. If the trade goes completely against you, take the original $2 profit per share you made when you sold the August $25.00 Calls.Use this to offset the cost to buy the stock for $22.50 per share.The most you can lose is the $1.75 per share difference between the Call option you bought for $3.75 and the Call option you sold for $2.00.

Maximum Return on Risked Capital:

The maximum return on risked capital for this trade is calculated by taking the profit for the trade ($0.75) divided by the cost to enter the trade ($1.75) ($0.75/$1.75 = 0.428 or 42.8% return).

Potential Play Directions:

At this point, the stock will move in one of three ways:up,down,or sideways.The next few pages detail how to handle each of these scenarios.

Stock Price Rises:

In the event the stock price closes above the strike price you sold on expiration Friday, then "Same-Day Substitution" (SDS) will occur. Same-Day Substitution means that a change will occur in your account that will not result in a net change to the value of the account. What it really means is that the Options Clearing Corporation will go into your account and see that you don't own the stock, although you have sold the $25 Call options. The OCC will exercise the $22.50 Call that you bought, and then sell the stock for $25 that same day.This all takes place in your account automatically.You don't have to worry about placing any orders to make this happen, and what's even better, you don't even have to have the cash in your account in order to buy the stock at $22.50. The computer recognizes that the sale of the stock for $25.00 will result in a net profit to your account and acts accordingly.

Stock Price Drops Slightly:

In the event the stock price drops slightly below the strike price you sold, but stays above the strike price you bought, the options you sold will expire worthless. However, before expiration Friday, you need to sell the options for the strike price you bought, for whatever value they still hold.Your profit on the trade comes from any profit you retain on the sale of the options purchased less the cost to first enter the trade.

Using the price examples above, this is how the scenario would work:
the stock has fallen slightly below $25 per share. The $25 strike price Calls that you originally sold will expire worthless.Before expiration Friday, you would need to sell the $22.50 strike price Calls you originally purchased as part of the spread for whatever value you can get. As long as the stock stays above $22.50, you will earn something from the intrinsic value of the $22.50 option. In the event that this intrinsic value is more than the original price you paid for the options, you will walk away with a profit.

Another important consideration here is your level of trading authority. If you're only approved for Level 3 options-trading authority, you'll need to buy back the $25 Calls before you'll be able to sell the $22.50 Call, otherwise you'll find yourself in a naked trade.The order of transactions is irrelevant if you have Level 4 trading authority.

Stock Price Drops Heavily:

Should the stock drop heavily on bad news with a negative outlook, sell to close the option that you originally purchased for as much as you can get for it. Any potential profit is dependent upon you selling your option for as much as you can get in order to offset the original cost to enter the rade.

Again, your level of options-trading authority is of primary consideration. With Level 3, you'll need to buy back the Call options you sold before you can sell the $22.50 Calls. The good news is that the $25 strike price Calls are likely to be very inexpensive.

Summary:

Although it's a debit type spread, where you are initially required to pay more to enter the trade than you initially make in revenue, a Bull Call Spread can be a great way to earn income in a manner similar to a Covered Call, without having to go through the trouble of buying the stock in the first place. The Bull Call Spread also works great in the event you don't have enough capital in your account to go out and purchase the stock for a Covered Call.

You would consider using a Bull Call Spread if you are neutral to mildly bullish on a stock.

To place a Bull Call Spread trade, first make a purchase of at least one call option two strike prices in-the-money below the current price of the stock. Next, sell at least one call option one strike price in-the-money.

If the stock closes above the Call option you sold, the Options Clearing Corporation will go into your account on Saturday following the third Friday of the month to purchase the stock for the strike price you sold. When they see that you do not own the stock, they will automatically exercise the Call you bought. Since the Call you bought was deeper in-the-money than the Call you sold, your account receives a net profit for the transaction. The net profit for the exercise of your options, minus the net debit to your account on the initial transaction, results in your maximum potential profit. This maximum only occurs if the stock closes above the strike price you sold by expiration Friday.

If things go wrong, and the stock closes below the strike price you sold, your actions depend upon your level of options-trading authority. If you have Level 3 authority, you will have to buy back the options you sold first, and then sell the option you originally purchased. In the examples used in this section, if the stock price closes below the $25 strike price you sold, you would have to buy them back first, before you could sell to close the $22.50 strike Calls you still own for any value they still may hold.

With Level 4 trading authority, you can simply allow the $25 strike price options you sold to expire worthless, and sell the $22.50 strike price options for whatever you can get.

Bear Put Spread

When you're feeling on a stock is generally negative, bear spreads are generally low risk, low reward strategies. One of the easiest ways to create a bear spread is by using put options at or near the current market price of the stock.

Like Bear Call Spreads, Bear Put Spreads profit when the price of the underlying stock decreases. Bear Put Spreads are typically created by buying at-the-money puts and selling out-of-the-money puts.

Example

Using Altria Group (MO), we can create a Bear Put Spread using in-the-money options. With MO Trading at $56.78 in May, you might buy ten of the JUL 60 puts and sell ten JUL 55 puts.

In this case, the maximum profit would be the difference between the strike prices less the $3,000 it cost to put on the position. In this case, the maximum profit works out to $2,000 ((60 - 55 x 1,000) - $3,000). In contrast, the maximum loss would be limited to the $3,000 spent initiating the trade. Once again, this maximum loss is the amount used to calculate the ROI.

• MO trading @ $56.89
• Buy 10 JUL 60 Put @ $4.00 $4,000
• Sell 10 JUL 55 Put @ $1.00 ($1,000)
• Cost of Trade $3,000