Options Spread Trading Explained: How to Add Options Trading to Any Investment Arsenal
by Karim Rahemtulla, Options Expert
Thursday, October 15, 2009: Issue #1116
“Why would I want to trade options? They’re too complex and scary. I’ll lose all my money.”
If I had a dollar for every time I’ve heard this from investors, I’d be kicking back on a Caribbean beach right now.
I actually love getting questions like this. It gives me a chance to bust a few myths and educate the person on why they should add options trading to their investment arsenal.
Simply put, options give you greatly increased leverage and several different ways to make money. What’s more, any investor can – and should – use options.
Three Return-Boosting, Risk-Reducing Option Strategies
Compared to stocks, which limit your ability to either play the upside or downside, options give you greater flexibility to manage both your returns and your risk.
Here’s how…
- Covered Calls: This is one of the most basic options trades. As the name suggests, you sell call options against an existing share position in order to “cover” yourself. Because there are 100 shares in an options contract, you must own at least 100 shares of a company to execute a covered call trade. When you do, you receive a premium from selling the call option, which essentially reduces the price you paid for the shares. But you also maintain a healthy upside. This enhances your return potential, while reducing your risk at the same time.
- Put-Selling: My colleague, Lee Lowell, has highlighted the excellent double benefit that comes from selling put options. Here, you try to buy a stock at the price you want (i.e. at a discount to the current price) and get paid for it, too.
- LEAP Options: This allows you to bet on a company’s long-term outlook – be it positive or negative. The additional duration of these options gives you more time to be correct with your call, and by buying LEAPS, you only use 15-20% of the cash required to hold the actual shares.
Time to bust another myth: Options trading is not gambling. When I use options – and recommend options trades to my readers – I don’t gamble. Quite the opposite, in fact. My goal is always to lower risk…
The Options Spread Trade: Putting You in the Driver’s Seat
So I come up with ways that put me in the driver’s seat, rather than just going along for the ride and “hoping” for a particular outcome – which includes one of my favorite option strategies that can generate significant wealth – the options spread trade.
Spread trading takes you one step beyond average investors and puts you in a position to generate the kind of returns you normally only see in advertisements. It works like this…
A spread trade requires two simultaneous transactions. For some reason, this is where most people decide to tune out. Their loss. It’s this extra step that can make the difference between making 20% and 200%, or 2,000%. I know that if someone offered me a chance to add a few zeros to my returns, I’d be all ears!
For the sake of simplicity, I’ll use a bull spread for this example…
Feeling Bullish? Rise to the Occasion with Spread Trading
A bull spread implies that you expect the price to rise.
Take gold, for example. If you think gold prices will shoot to $1,500 or $2,000 over the next 30 months, you can use a bull spread to play your prediction.
We’ll do it using one of the biggest gold producers – Goldcorp (NYSE: GG).
Regular investors would play it by simply buying Goldcorp shares for $40 a pop. For 1,000 shares, that’s a hefty outlay of $40,000.
Smarter investors, though, could buy the 2012 $40 Goldcorp call options (LGX-AH). This gives you the right to buy GG for $40. And for it, you only spend $13.30 ($13,330 if you want to control those same 1,000 shares – $13.30 multiplied by 1,000 = $13,330).
Let’s say you have a $60 target price for GG shares by 2012.
- The Stock Buyer: If you buy GG shares outright, you’d make $20 – or 50%. In dollar return terms, that would be $20,000 on a $40,000 investment.
- The Option Buyer: If you bought the LEAP option and Goldcorp rises to $60, your return would be $6.70 ($60 minus $40 minus $13.30 -the amount you paid for the option). That’s a dollar gain of $6,700 on $13,330 invested.
Not too bad at all. But if you take this one step further, you’d not only reduce your risk substantially, but boost your returns substantially, too.
Here’s what to do…
“Spreading” the Wealth
Having bought the $40 call option for $13.30 and ponied up $13,330 for 10 contracts (1,000 shares), I’d then sell the January 2012 $60 call option against it (LGX-AL).
When you sell an option, you first get money back for selling the option. It also limits your upside to the strike price of the option that you sold ($60).
The $60 call option is trading for $7.30. So…
- Buy the January 2012 $40 option. Cost: $13,330
- Sell the January 2012 $60 option. Receive: $7,330
- Net cost of the trade: $6,000 ($13,330 minus $7,330)
By doing this, we’ve entered into a spread.
- The Spread: The spread is the gap between the price at which we can buy GG and where we have to sell GG. In this case, the buy price is $40 and the sell price is $60. So the spread is $20.
- The Profit: In dollar terms, our maximum upside is $20,000 ($60,000 minus $40,000 based on 10 contracts or 1,000 shares), with a cost of $6,000. This means if Goldcorp hits $60 or more, we can make $14,000 net profit on a $6,000 outlay. That’s 233% ($14,000 divided by $6,000 cost).
- The Risk: What’s more important, though, is that our maximum risk here is limited to the cost of the spread – $6,000. That’s just 15% of the amount that a regular shareholder would have at risk if he bought the shares outright ($6,000 divided by $40,000) and probably much less than the stop-loss that most people would institute on the trade.
I’d much rather risk $6,000 to make $14,000 than $40,000 to make $20,000 in any market, especially this one. And if you dump the $34,000 that you saved by executing the spread trade into an account that earns just 2% interest, you’d offset your cost by a further $900 or so, too.
The Best Spread Trading Candidates
Next time you see a stock that you want to own, consider using this spread strategy to both reduce your cost and increase your upside at the same time.
This is the exact same trade I used in my 400 Report service recently to make 166% on Petrobras (NYSE: PBR). And while we could have held the position for two years, we cashed out in less than six months (yes, you can close out these trades early if you’re sitting on a handsome profit).
You can execute spread trades on any stocks that have options available. But the most popular stocks for spreads are volatile and expensive ones. Companies like Apple (Nasdaq: AAPL), Google (Nasdaq: GOOG) and Research In Motion (Nasdaq: RIMM) are ideal candidates.
Good investing,
Karim Rahemtulla
Any investment contains risk. Please see our disclaimer.
7 Responses to “Options Spread Trading Explained: How to Add Options Trading to Any Investment Arsenal”
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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. 
Fabulous article. Thank you, well written and simplified for the novice.
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Great article. Explained in a very simple and clear way with given examples. Thanks.
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Will a change in volatility affect the risk and return ratio?
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Hi
Karim mentions that in a bull spread he closed the trades well before the expiry date. How do you actually close the write call option? Do you buy that call option back? How does this process work in the exchange?
Regards
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Hemraj,
To close out a bull spread before expiration, you must sell your lower priced call option that you bought and buy back the higher priced call option that you sold.
Good investing,
Investment U
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Karim,
Good article! Please consider supplementing it by spelling out the mechanics of what happens when the calls expire with the price of GG:
[1] north of $60
[2] between $40 and $60
[3] south of $40
It would be good if you covered what happens by default (if you give no instructions to your broker) and other reasonable choices you might make in each scenario. (Not that there would be many choices in scenario [3].)
E.g., in scenario [1] a reasonable question might be: “On the day the options expire, will my broker (presuming I don’t instruct him differently) sell my $40 call and buy back my $60 call (which would net me a profit) or actually exercise the $40 call in order to have shares to sell at $60 when the call I sold is exercised? If the latter, do I need to have $4000 cash in my account to cover the intraday purchase of the shares?”
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Hi rahim,
some how i understood your message, was good and would like to know the ideas in currency trading for this do you publish any books or any other. Actually i trade on currency market in india, but i am not able to dedect the price action and make profits. I trade at MCX-SX.
Please let me know some ideas.
Reagards,
J.Michael Jacob.
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