Your Guide to Understanding Vertical Bull and Bear Option Spreads

Transcription

1 A Publication of The Sovereign Society Your Guide to Understanding Vertical Bull and Bear Option Spreads By Andy Hecht When most people think of trading options, they think of buying call options or put options. You buy call options when you think a commodity or stock will rise and put options when you believe a certain commodity or stock will fall. As an options trader with over 30 years experience, I can tell you this simple strategy does work. It gives you the potential for unlimited rewards, while strictly limiting your risk. But sometimes, it s not enough. Sometimes, markets move fast, and options suddenly spike in price. When that happens, option premiums can become very expensive very fast. The more expensive your desired option is, the more risk you must take on to buy that option. I often talk about the risk-reward ratio of each options trade. Ideally, you want a low risk-high reward ratio, so you re shooting for big gains with as little risk as possible. As option premiums rise, the cost of buying options can become so ex- The Sovereign Society 98 S.E. 6th Avenue, Suite 2 Delray Beach, FL USA USA Toll Free Tel: (888) Contact: Website:

2 pensive that you can t get enough reward for the amount of risk you re taking on by buying that option. When that happens, the trade may no longer make sense. Fortunately, there is a strategy you can use when option premiums spike in price and simply buying calls or puts won t cut it. It s called a vertical option spread. Option Spreads 101 A vertical option spread involves buying one option and selling another option against it at the same time with the same maturity and different strike prices. You use these types of spreads to limit risk, by lowering the cost of a bullish or bearish position. Option traders use spreads during times when option premiums are expensive and do not justify a simple long call or long put purchase. For most investors, a vertical option spread is a brand new trading strategy. And, I understand this type of trading takes some getting used to. What s important to know is you use option spreads to limit your risk, give you the potential for gains, give you further flexibility in your trading, and let you take advantage of more expensive option premiums. There are four kinds of vertical options spreads to become familiar with. They are: Vertical Bull Call Spread a bullish strategy Vertical Bull Put Spread a bullish strategy Vertical Bear Call Spread a bearish strategy Vertical Bear Put Spread a bearish strategy In the future, we may trade any of these spreads I ve listed above. In upcoming issues, I ll give you exact details on how to trade these spreads as opportunities arise. However, to give you an idea of how vertical option spreads work, I m going to walk you through an example with the first type of spread the vertical bull call spread. Vertical Bull Call Spreads The Bullish Strategy You would execute a vertical bull call spread when you believe a specific commodity is going to rise in price, and option prices or premiums are relatively expensive. So say you think corn prices might rise, but the call option premiums are ridiculously high. You might choose to execute a vertical bull call spread on corn instead. A vertical bull call spread involves buying a call option in a stock or commodity at a low strike price and simultaneously selling a higher strike price call option in that same stock or commodity with the same maturity date. So let s go back to our corn example for a moment. By using this strategy, you would be buying an expensive call option on corn. But at the same time, you would also be selling an expensive call option on corn. As an option seller, you would instantly receive income for selling the call option with the higher strike price. This results in lowering the price that you have to pay for the first call option. What you will wind up with is a bullish options strategy with limited risk, a cheaper entry price and a limited re- 2

3 ward horizon. Also, like with any long option, you re only risking the premium you pay for the long corn call option contract minus the short call option contract at the higher strike price (for the same maturity). Now let s say corn prices shoot higher, while you own this vertical bull call spread. If corn prices rise above the strike price of your lower strike price call option by more than the premium of the spread, then you profit. And you ll continue to profit penny for penny up to top end of the spread (the price of the call option you sold). Specifically, the most that you can earn on this type of spread is the difference in the strike prices, minus the premium you paid for the spread in the first place. The equation would look like this: The difference in strike prices (if the price at expiration is above the higher strike price call) Minus premium you paid for the spread = Your maximum profit -or- The final price at expiration (if the final price is below the higher strike price call option and above the lower strike price call option) Minus the premium paid for the spread = Your profit or loss You can calculate the premium for this type of spread by subtracting the premium you received on the higher strike price call from the price you must pay for the lower strike price call. For example, say you bought a $7-$8 vertical bull call spread in May corn for 20 cents and the market moves to $9 on expiration. That means you will make 80 cents on the trade. Using our formula above, this is a bit easier to figure out (-The difference in strike prices of the spread) Premium you paid for the spread = Your Profit ($8 $7) 20 cents = 80 cents Paying 20 cents for the spread, and getting 80 cents back, means you quadrupled your money. In other words, you just made a 400% return. The level that you would breakeven (make no money but lose no money) on the trade would be $7.20 every cent above $7.20 up to $8.00 would be your profit zone. And, since you bought the spread, every penny above $8 at expiration would simply lock you in to your maximum profit of 80 cents on this trade. Not bad, and it was all possible because you didn t just settle for buying the high-priced call options on corn which would have posed a much greater risk! In the example of just buying the high priced call option, where the $7 call option was $1, you risked $1 to make $1 you made a 100% return. Using the vertical bull call spread above you risked 20 cents to make 80 cents a 400% return! It is so important to pay attention to the risk reward ratio of a trade when using options! Spreads Give You Flexibility So You Can React To Whatever the Market Gives You Even better, this strategy (the vertical bull call spread) gives you the opportunity to trade the position. By trading, I 3

4 mean make adjustments to this position as needed for even greater profits. For example, say the market moves against you while you re in this corn bull call spread, and corn prices tank. But you re still bullish on corn overall. You think prices will go higher by the time the options expire. In that case, you can buy back the original higher strike price corn call option that you sold when you put the spread on. Even better, you can buy it for cheaper than you sold it for initially because the price of the underlying commodity or the corn went lower. By buying back the high-priced call option, you give yourself room for unlimited gains. For example, say you bought back that $8 corn call option you originally sold on a dip in corn prices during the life of the spread. Let s say you are able to buy it back for 4 cents on a dip. If the corn market climbs to $9 at expiration, you make $1.76 instead of that original 80 cents! Let me explain how By buying back that $8 call option, you re covering your short higher call option position. In doing so, you re opening your trade up to more gains. You paid an additional 4 cents to close that $8 call option. That brought your total cost of the spread up to 24 cents or the original 20 cents you paid for the spread plus the 4 cents you paid to buy back the short $8 call option. If the price of corn climbs to $9, your profit is the difference of the strike price ($7) and the market at expiration ($9). So your profit is $2. However, you also have to subtract your costs, or what you paid for the original vertical call option spread (20 cents), and to cover the option (4 cents). So your profit would be $2 24 cents, or $1.76. In this example, the total cost of the options was 24 cents. Also, at expiration, the $7 call was $2 in the money ($9 current market versus the $7 call option). Here s a formula to make it easier (Price at expiration Original Strike Price) (Premium You Paid for the spread + Cost of Covering that Call Option) = Your Profit ($9 - $7) (20 cents + 4 cents) = Your Profit $ = $1.76 So you paid 0.24 cents and got $1.76 in return. That s a 733% return. The flexibility of trading against the spread allowed you to turn a potential 400% profit into a 733% profit by covering the short option on a dip in the corn price! Putting It All Together The vertical bull call spread is just one example of an options spread. As I mentioned, there are three other vertical option spreads that allow you to bet for or against a specific commodity or stock, depending on your outlook. I ve listed these other strategies below 1. Vertical Bull Put Spread another bullish strategy you use when you believe a certain commodity or stock is going to rise in price. It involves buying a put option in a stock or commodity at a low strike price and simultaneously selling a higher strike price put option in that same stock or commodity with the same maturity date. 2. Vertical Bear Call Spread a bearish strategy that allows you profit when you believe a stock or commodity will plummet in price. It involves buying a call option in a stock or commodity at a high strike price and simultane- 4

5 ously selling a lower strike price call option in that same stock or commodity with the same maturity date. 3. Vertical Bear Put Spread If you believe a certain commodity is going to drop, you also might use a vertical bear put spread to profit off that bearish position. A vertical bear put spread involves buying a put option in a stock or commodity at a high strike price and simultaneously selling a lower strike price put option in that same stock or commodity with the same maturity date. There is no need to memorize these. I ll be giving you details on how to trade these spreads when I see the best opportunities to do so in upcoming issues. I just wanted you to know that they exist, so you re prepared for such recommendations in the future. I like to use this type of strategy when option premiums get really expensive and offer a good risk-reward ratio for selling options. A minimum risk-reward to me is at least 1:1 or in other words I don t want to lose more than I can make! Generally I like to buy options and have an unlimited opportunity to profit when I get the market right! However, when option premiums become too expensive the risk of buying outright call or put options can become prohibitive. By using vertical option spreads we can achieve the best of both worlds! 5

6 The Sovereign Society 98 SE 6th Avenue, Suite 2 Delray Beach, FL USA USA Toll Free Tel: (888) Website: Legal Notice: This work is based on what we ve learned as financial journalists. It may contain errors and you should not base investment decisions solely on what you read here. It s your money and your responsibility. Nothing herein should be considered personalized investment advice. Although our employees may answer general customer service questions, they are not licensed to address your particular investment situation. Our track record is based on hypothetical results and may not reflect the same results as actual trades. Likewise, past performance is no guarantee of future returns. Certain investments such as futures, options, and currency trading carry large potential rewards but also large potential risk. Don t trade in these markets with money you can t afford to lose. Sovereign Offshore Services LLC expressly forbids its writers from having a financial interest in their own securities or commodities recommendations to readers. Such recommendations may be traded, however, by other editors, Sovereign Offshore Services LLC, its affiliated entities, employees, and agents, but only after waiting 24 hours after an internet broadcast or 72 hours after a publication only circulated through the mail. Also, please note that due to our commercial relationship with EverBank, we may receive compensation if you choose to invest in any of their offerings. (c) 2011 Sovereign Offshore Services LLC. All Rights Reserved. Protected by copyright laws of the United States and international treaties. This Report may only be used pursuant to the subscription agreement. Any reproduction, copying, or redistribution, (electronic or otherwise) in whole or in part, is strictly prohibited without the express written permission of Sovereign Offshore Services, LLC. 98 SE 6th Ave, Suite 2, Delray Beach FL