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Bull Spreads

The Smart Profits Report: Issue #248
Friday, October 07, 2005

Bull Spreads - Bagging a 66% Return on Lexar
By Karim Rahemtulla
Chairman, Mt. Vernon Research

This week, subscribers to my trading service notched some fat profits - about 66% in just under six months, on a company called Lexar Media.

Lexar is a manufacturer of memory chips that are used in electronics. What is more important is the strategy we used (and which you can use), and why we used this particular strategy.

First, we used a strategy called a “bull spread.”

A bull spread involves buying an option at one strike price and selling another option at a higher strike price against it - kind of like covered calls, where you buy a stock and sell an option against the shares. But in this case it was an options-only trade.

Breaking Down the Lexar Bull Spread

In the case of Lexar, we bought the $5 calls for $2.65 and sold the $7.50 calls for $1.90. This means we had a net debit or cost of $0.75 ($2.65 minus $1.90). It also means that our upside was limited to the spread: the difference between the two strike prices, or $2.50.

So, we invested $0.75 to make $2.50.

This week, we bought back the $7.50 calls for $2.75 and we sold our $5 calls for $4, for a net gain of $1.25. Now, you subtract your original investment of $0.75 and you have a net profit of $0.50 on the trade, on a total of $0.75 at risk, for a gain of 66%.

We closed this position early - by more than a year. Why?

One of my favorite sayings is “a bird in hand is worth two in the bush,” or something like that. That is the reason we covered early.

Why We Chose a Bull Spread In This Case

Now, the reason why we used the spread to begin with…

When an option is very expensive relative to its share price, I always look for ways of reducing our cost. In this case, the $5 option was trading at almost 50% of the share price - quite steep.

But, that also means that the other options at different strikes would be expensive, as well. So while I limited my upside, I also substantially reduced my downside.

I also knew that I would be able to cover early if the shares moved higher, because the options that were closer to the strike would gain more as we moved past the strike price than the options that were out of the money, since one would be building intrinsic value.

And, finally, I don’t like to risk more than 10% to 15% of the underlying share price on any LEAPS trade, and the only way to achieve it on Lexar was to use a spread. The next time you find yourself looking at a similar situation, consider using a bull spread.

Good trading,

Karim Rahemtulla

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One Response to “Bull Spreads”

  1. SmartOptions » Blog Archive » Condor Spread on June 13th, 2008 10:39 am

    [...] Bull Spreads - Bagging a 66% Return on Lexar  100705 [...]