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Spread Trading
The Smart Profits Report: Issue #467
Wednesday, October 24, 2007
Spread Trading: Lower Your Cost And Hedge Your Risk In One Profitable Bull Spread Trade
By Karim Rahemtulla
Investment Director, Mt. Vernon Research
One phrase that many regular investors don’t expect to come across when trading is “options spread trading.”
As it is, the options world can be a mystery to these folks, so tossing in option spreads seems doubly intimidating.
But we’re not regular investors. Once you cast your fears aside and learn how to use options and spread trading, you’ll find that they’re one of the best moneymaking tools in the market today. Let’s take a look at how they work…
Two Advantages Of Spread Trading
First of all, what exactly is spread trading and a spread?
Simply put, it’s a professional trading strategy that consists of two separate positions - no matter what type of spread you’re using.
The common goal is t
- Initially lower your purchase cost,
- Then hedge your risk throughout the duration of the trade.
However, as you probably know, there is no free lunch on Wall Street and spreads do limit your upside return. The best way to explain a spread trade is to show you how one works. And while there are many different types of spreads, I’m going to focus on one of the most common: Bull Spreads.
When Options Are Expensive, Spread ‘Em!
Let’s say we want to buy call options on Freeport McMoran (NYSE: FCX), but as we pull up the options chain, we see that they’re very expensive. Bummer, huh? Many folks would walk away at this point. But rather than just give up, spread trading is a particularly effective strategy when you’re faced with pricey options.
This was the exact scenario that my LEAPS Trader subscribers and I faced just a few months ago. So here’s what we did…
At the time, FCX shares were trading for $62 and I was optimistic that they would move higher. But the $60 1-year LEAP options were trading at $6 (remember, buying at the $60 strike price gives you the right, but not obligation, to buy shares at that price when the options expire).
So rather than risk $6, we decided it would be better to reduce the dollars at risk and go for a bull spread. You do this when you’re betting that the share price will move higher, and it involves buying the lower strike price option and selling the higher strike price option against it.
So I checked the price on the $70 option. It was trading at $3. So we sold those options against our $60 options. Here’s the next move…
Number-Crunching The Spread Scenario
The effect of buying the $60 option and selling the $70 option would result in the following scenari
- We paid $6 to buy the $60 strike, so we were out of pocket $6 per share.
- But we then sold the $70 option for $3, receiving $3 per share for our efforts. So our adjusted cost is $3 ($6 minus $3).
- But remember, I said that with spread trades, your upside is limited. And in this case, the upside is $10 - the difference between the $60 strike and $70 strike.
Bottom line: We risked $3 to make $10. And as long as FCX close above $63, we will make money ($60 strike plus $3 cost of the option). If the shares close above $70, I will make $10 for each spread that I entered (less the cost of the spread). Sure, we could go higher - maybe to $80 - but then we’d receive less for selling the $80 option.
If FCX closes below $60, we lose our entire investment of $3. But we can never lose more than $3 as long as we hold the position until expiration.
In real life, however, spread trades aren’t always held until expiration. Instead, investors usually cover them early, in order to take advantage of the decaying time value of the higher strike.
It’s Easy… It’s Professional… And It’s Profitable
By executing a spread trade, you accomplish two things.
- First, you invest in a very expensive stock for very little money.
- Second, you reduce your risk by decreasing your cost.
In the real-life trade above, we didn’t wait until expiration. We got out of the trade by buying back the $70 strike and selling the $60 strike early. Result? A 65% profit - in just a few weeks.
My biggest returns have come from spread trading - and in some cases, we’re talking about thousand-percent returns. What’s more… trading spreads is not difficult. You just have to get your broker’s blessing before you can do it.
Karim Rahemtulla
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Today’s Smart Profits Action Center
- Are you investing like a pro, or just like the rest of the crowd? Over 95% of investors prefer the high-cost, high-risk, low-return investing choice. Not only do they buy stocks for huge money down, they then compound it by exposing their money to more risk than necessary. Spread trading is one of the best ways that investors can both lower the original purchase price and minimize risk. For more information on spread trading, check out Smart Profits #330, Option Spread Trading: How a Bear Spread Can Make You More Than One Put Options Trade.
- Our resident commodities expert Lee Lowell calls it his “all-star strategy” and “my favorite ‘option-selling’ strategy of all time… that I execute more than any other for my personal accounts.” That’s high praise from a guy who spent six years as a market maker at the New York Mercantile Exchange, setting the daily prices for commodities like natural gas. It’s a strategy he’s written about extensively in his book, Get Rich With Options: Four Winning Strategies Straight From The Trading Floor. Find out what it is - and how to execute it like a pro - by clicking this link.
Related Articles:
- The Bull Calendar Spread: How To Use This Trading Strategy To Bag 133% Now Or 4,900% Later
- Understanding Bull Spreads: Make 1,000% or More by “Spreading” the Wealth
- Spread Trades & The Market Maker: Two Valuable Options Lessons From Boston
- LEAP Options: The Intel Bargain & A Potential 566% Return
