Understanding Bull Spreads

The Smart Profits Report: Issue #151
Wednesday, October 13, 2004

Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
By Karim Rahemtulla
Chairman, Mt. Vernon Research

Buying an option and watching it soar because the underlying stock moves is the best-known and easiest strategy to understand… but it sure as heck is not the best way to make money with options. In fact, the “straight” buy of an option could be the ABSOLUTE worst way for most people to try to make money. It requires a lot of expertise and risk tolerance to trade options like that, especially for the short run.

I’ve said it may times before, and I am sure I will say it many times again: If you don’t have a system to trade options, you ought to just buy your significant other a nice present with the money you were going to spend. At least someone will walk away happy!

This week I want to show you a way to make some big money with very low risk by understanding bull spreads.

How the Pros Preserve Upside AND Cut Risk

That’s right, I used “big money” and “low risk” in the same sentence… about options no less.

It’s a strategy that is called a bull spread. It sounds a little painful, but it is a strategy that many professional traders use to cut down on risk while still preserving upside. There are two times that a bull spread can be used effectively.

On an expensive stock where even the options cost a lot

When your options are already profitable and you want to go the rest of the way without losing what you’ve made

When Options are Cheaper But Not Cheap, Bull Spreads Are Key

For starters, what is a bull spread? It’s a simple combination of two options: you buy a call at the current price of the stock and you sell a call at your upside target price.

That strategy means that if the stock goes up, you’ll make money… but the amount you can lose is limited. The call you sold not only earns you a bit of change, but it cuts your risk short.

Let’s look at a sample trade to see how this works. Here’s what I mean about using bull spreads with an expensive stock…

Let’s say you are hot on Amazon.com. You love the stock, but it’s expensive. You could buy a call option for a fraction of the price of the stock, but even that fraction is very expensive. That’s the time to look at a bull spread.

The first step is to figure out how much you are trying to make (your target exit point) because that’s the strike price you are going to use on the call you will sell. But before we get that far, let’s look at how a regular stock trade might work out for you so we see how much better the bull spread is.

Anatomy of a Bull Spread - And How It Beats a Stock Trade

If you were trading the stock, you wouldn’t just look at your potential winnings if you were smart. You’d also set up a stop loss.

Let’s assume that Amazon is $42 today, and your target is $50 in a year. That’s about a 20% gain. Nice. But to own 1,000 shares of Amazon you would pony up $42,000 - not small change for most investors.

As for your stop loss, let’s say you set it at 15%. If Amazon fell from $42 to $36 you would get out of the position, with a $6,000 loss on your 1,000 shares.

Okay, now you know what you stand to make on the underlying stock - up 20% if you’re right - and what you’d lose if you had to bail: 15%.

As you can see right away, that’s a lousy proposition.

Buy One Call at the Current Price; Sell One at Your Target

Now let’s look at the option version. You pull up the options chain - a list of options and their prices - for Amazon. The $40 call option expiring in a year is $6 per option - pretty darn steep. But it’s the strike price that is closest to the stock. You want a slightly in-the-money or right-at-the-money strike price for the bull spread.

That takes care of the first of your two options, so you know which call to buy.

Figuring out which call to sell is even easier: it’s your target for the stock. You think the stock is going to $50 in a year, so you sell a $50 call. It’s that simple. As it happens, the price on the $50 call is $2.

I repeat, buy a call near the current price, sell a call at your target - that’s a bull spread. For this trade you bought a $40 call and sold a $50 call.

Now what?

Let’s review the equation. You now own the Amazon $40 call at a net price of $4 - 33% less than your cost. And your upside is $10 (50 minus 40), less the $4 you have at risk. So you stand to make 150% on your money or $6,000 in profits if Amazon closes at $50 or above.

Your total risk is $4 for the call, or $4,000, versus $42,000 if you owned the shares. Not bad.

Charging Forward, for 900% Profits

Here is another way to play the bull spread. Let’s say you own the Amazon $40 call option for $6. Six months into the trade, Amazon is at $48 and your option is trading at $10. You could sell your option and take your money off the table or let it ride and risk all of your profits AND your investment.

Here’s a better solution. Hold on to your starting position and sell the Amazon $50 call expiring at the same time. For that option you will get about $5, reducing your cost to $1 per contract.

You have done two things. First you have limited your upside to $50 (your original target). But your cost in the trade is now $1 instead of $6. And instead of making 66% if Amazon is at $50 at expiration (or before), you now stand to make over 900%. With the spread, you stand to make $9 on every $1 at risk.

How often can one make profits like this?

Using bull spreads, more often than you might think…

Good Trading,

Karim Rahemtulla

Today’s Smart Profits Cribsheet

In the Leaps Option Trader portfolio we closed out a Lockheed Martin trade for 1,100% this year, along with… a triple-digit profit on Yellow Corp. We are now sitting on gains of more than 150% on Placer Dome and over 2,500% on Chesapeake Energy. To read more about the LEAPs Option Trader, just visit us.