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Spread Trades

The Smart Profits Report: Issue #280
Thursday, February 2, 2006

Spread Trades: Bull vs. BearHow To Turn A $50 Bill Into $2,450
By Karim Rahemtulla, Chairman, Mt. Vernon Research

Spread trades are one of my favorite trading vehicles. They reduce your risk by putting less money on the table and they increase your upside. You’re just not going to find too many deals that can do that.

A spread trade is when you buy a call option at one strike price and sell another call option against your position at a higher strike price - this is a bull spread. A bear spread would entail buying a put option at one strike price and selling another put option at a lower strike price.

The purpose of a spread trade is two-fold. First, it bets on the direction that you think a certain stock will go. And second, it reduces your cost of the trade to the difference between what you pay for the option and what you get from selling the second option.

Your profit is the “spread,” or the difference between the two strike prices, minus your cost of the spread.

Let’s look at two trades we executed in one of my trading services. One is a conventional bull spread, and the other is slightly less conventional.

A Fast And Safe 100% Gain with Spread Trades

A few months ago in my LEAPS Options Trader, we entered a conventional bull spread on Placer Dome (NYSE: PDG). We bought the $17.50 LEAPS calls and sold the $25 LEAPS calls against our position. Our net cost was the difference between what we paid for the $17.50 option and what we received for selling the $25 option.

If you follow the gold stocks, you know that late last year Placer agreed to be taken over by Barrick Gold. We made nearly 100% on our spread in a matter of a few months, with low downside risk.

The second type of spread trade is called a legged spread. About a year and a half ago, we bought options in Chesapeake Energy (NYSE: CHK). Once those options increased in value by about 40% in a short period of time, we had a choice: We could either sell the option and take the profits, or we could engage a spread trade AFTER a few months of owning the call option.

So, I looked at the next strike price higher than the one we owned. Based on that price, we could sell the next strike higher and recoup all but 5 cents per contract. Our cost in the option was $2.50, and we received $2.45 for selling the second option. The spread was $2.50 between the two strikes.

Here’s Where the $50 Bill Comes In

The equation is as follows: We are now at risk 5 cents to make $2.50. In real dollars, if you invested $2,500 in the initial trade, you would receive back $2,450, leaving you with a cost of $50. At last January’s expiration, that trade was completed as both options expired.

In sum, those who participated in the spread trade made a net profit of $2,450 on $50 at risk. By using some of the gains from the LEAPS trade for our spread, we multiplied our leverage. Imagine if you had risked several hundred dollars or more.

We closed out three other spreads as well, in Lexar, IGT and IACI, that netted strong double- and triple-digit gains. We also closed out a very profitable spread trade on Goldcorp (NYSE: GG) in the Xcelerated Profits Report for huge short-term profits on the back of soaring gold prices.

Spread trades are not for everyone. They usually have special margin requirements and may require staying in a position for a longer period of time to fully realize the gains. But, with gains like the ones above, there is no doubt in my mind that learning about and using spreads trades is a meaningful addition to your trading arsenal.

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Today’s Smart Profits Cribsheet

  • In this issue, I mentioned our gain in Lexar by using the bull spread. To read more about how we made the trade, take a look at Smart Profits #248 Bagging a 66% Bull-Spread Return on Lexar.
  • The Goldcorp spread from the Xcelerated Profits Report is just one of the many profitable trades we initiate on a monthly basis. Right now, there are multiple covered call positions in the portfolio and we just realized a 55% gain with a LEAPS option on a tech giant. Learn more about the Xcelerated Profits Report.
  • Check out the Smart Profits Glossary, chock full of over 150 option terms, with definitions for words like, “spread trade” or “bear spread” found in today’s article.

Good Trading,

Karim

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