Spread Trading: Lower Your Cost And Hedge Your Risk with Bull Spreads
by Karim Rahemtulla, Options Expert
Wednesday, October 24, 2007: Issue #467
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?
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 to:
- 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…
Using Bull Spreads: When Options Are Expensive, Spread ‘Em!
While there are many different types of spreads, I’m going to focus on one of the most common known as bull spreads.
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 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…
With Spread Trades Your Upside is Unlimited…
The effect of buying the $60 option and selling the $70 option would result in the following scenario:
- 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
Related Investment U Articles:
- The Legged Spread Trade: Take 10 Cents and I’ll Show You How to Make It $2.50
- How to Recover When Your Option Trades Turn Against You
- Put Option Credit Spreads: Three Ways to Win – And an 80% Chance of Success
- Options Pricing: Use the Black-Scholes Model to Get a Fair Price for Your Options
- LEAP Bear Spreads: If You Want to “Go Short,” This is the Way to Do It
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Dubbed a "market maven" by CNBC, Karim Rahemtulla is one of the country's foremost specialists in options trading. As founder and editor of The Smart Cap Alert, he focuses his efforts on all aspects of options trading – LEAPS, put selling/covered calls and spreads. 
I have been looking at many sites and found yours extremely useful. There is clearly lots to learn on this subject. Can anyone recommend other good places to search for this information?
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