Legging Into a Spread

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Legging Into a Spread: An Option Strategy That Makes The Market Pay You

by Karim Rahemtulla, Advisory Panelist
Friday, October 23, 2009: Issue #1122

It’s always rewarding to notch up a big win on a trade – be it a stock, option, or otherwise. But before you pull the trigger, consider that you may be leaving money on the table.

However, there is a way to take an ordinary profit and supercharge it into a blockbuster return. We’re talking about the kind of return that bags you not just a few hundred percent… but a few thousands of percent.

As someone who primarily trades options – and shows investors how to use the most lucrative options strategies (together with specific recommendations) – I’ve seen this happen numerous times over my 20-plus years of investing experience.

So can investors incorporate quadruple-digit winners into their portfolio? In my last column, I showed you how to execute a spread trade. This is where you buy one option and sell another one against it, thereby reducing your cost and increasing the return on your invested capital. And while your upside is capped, your downside is protected, too.

Now, I am going to take you one step further, using a real-life example that I recommended to readers of my 400 Report service, the strategy is called “legging into a spread.” Stick with me here – it’s not confusing…

How Legging Into a Spread Works

“Legging into a spread” works just like a regular spread trade in that you sell an option against one that you already own. However, the difference is that you don’t sell an option right away… you do it after you already have a sizeable gain in your current trade.

And here’s the best part: Using this strategy, you will be able to reduce your cost to $0, or even have a negative cost, and the market will be paying you to be in the trade. Furthermore, you’ll increase your upside potential on the trade as well.

Here’s how it works…

Once we had decided to play the oil and natural gas firm Chesapeake Energy (NYSE: CHK), we did the following…

~ Bought the $12.50 call options, with 15 months until expiration. For that, we paid $1.20 per contract. (One contract = 1,000 shares)

When Chesapeake shares moved to the $14 level, our call options rose significantly. While this was obviously a positive development, it wasn’t really relevant to what we wanted to do. We could have taken our profits and moved on, but we decided not to.

Instead, we did this…

~ Because Chesapeake shares were rising, the decision to “leg into a spread” was easy. So we looked at the $15 call options, trading for $1.15 per contract, and sold them against the $12.50 ones that we bought. When you sell anything, including an option, you immediately receive money in your account.

Legging Into a Spread: Grab a 5,000% Return With Just $500 at Risk

Let’s break down this “legging into a spread” example to work out the profit…

Let’s say we bought 100 contracts of the $12.50 call options at $1.20 per contract. This represents 10,000 underlying shares of Chesapeake, since there are 100 shares in each options contract. This cost us $12,000 (10,000 shares multiplied by $1.20 = $12,000).
However, when we sold 100 contracts of the $15 call options for $1.15 each, we received $11,500 back into our account (10,000 shares multiplied by $1.15 = $11,500).
Risk: That leaves us with a net outlay of $500. So if we held the position to expiration, our maximum risk is $500.
Profit: By selling the $15 option, our upside is $2.50 ($15 minus $12.50), based on the spread. So if Chesapeake closes at $15 or higher at expiration, the most we can make is $25,000 in gross profit ($2.50 multiplied by 10,000 = $25,000) and $24,500 in net profit, given our net outlay of $500.

In this real-life trade, Chesapeake did indeed close above $15 at expiration, meaning we made $25,000 for every $500 at risk – gains of close to 5,000%.

Equally important, though, was the fact that we limited our risk from the $12,000 that we originally invested to just $500.

This type of trade is not unusual. In my 400 Report advisory, we have three other current trades just like this one, the mechanics of which are all the same. If you’d like to get more information on these trades – and all the others I recommend to my readers – take a look at this report and join the team.

The bottom line is this: If you have profitable options trades in your portfolio, you should always consider “legging into a spread.” The only prerequisite is that you need to allocate enough time for the shares to move higher – something that is possible when you trade long-term options.

Good investing,

Karim Rahemtulla

12 Responses to “Legging Into a Spread: An Option Strategy That Makes The Market Pay You”

Ken Graber Says:
October 23rd, 2009 at 10:58 am
When CHK closed above $15.00, didn’t you have to make good on the calls you sold by buying 10,000 shares @ $15.00? At the very least you had to buy the calls back.

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jsmith Reply:
October 23rd, 2009 at 6:01 pm
sold the calls for $15 means sell the shares for $15. But bought the long expiry calls for $12.50 means that you buy the shares (if you wish or in this case need to) for $12.50 – in order to sell them for the $15 commitment. Upside $2.50 / share x 10000 shares

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dave w. Reply:
October 25th, 2009 at 8:31 am
That’s where the 12.50 calls that were purchased originally are for.
You couldn’t even sell options unless you already had purchased either calls or stock (or had a huge account).

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Investment U Reply:
October 27th, 2009 at 1:32 pm
Ken,

Yes. When selling a call, we trade away the upside of shares rising above the strike price for an extra return up front.

Thank you,

Investment U

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dana hutchins Says:
October 23rd, 2009 at 11:41 am
this is the best that i’ve read in a very long time. thanks!!

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L. Lawver Says:
October 23rd, 2009 at 12:09 pm
The articles were concise, easy to read and the examples were easy to understand even for a “newbie” like me. Thank you!! Two Questions.
1. How can I find reliable Option Trader service (Broker?) and what are the estimated expenses to do the trade purchase, the “puts” and “calls” and the close-out of trade. 2. What are the federal tax consequences on the “legging into a spread” method and what accounting system would I need?
Appreciate Unvestment U and the quality people you promote.

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Robert Says:
October 23rd, 2009 at 12:35 pm
A very good explanation on how to reduce your risk after the stock has directional moved in your favor. This strategy does not eliminate the risk of your inital position if the stock does not move in your favor you are still at risk 12,500. My point is your article is misleading; 5000% return with little risk which is not true…There was a big risk initally and your explanation is not the proper way to evaluate the trade… there is no way of eliminating risk related to generating a high return, as you tried to makes us believe… FYI If your analysis determine CHK had limited downside & was in an uptrend then you could have sold out of the $$ puts to finance the trade and/or lower your cost.. I know risk with selling naked puts but really to geberate high returns there must be risk.

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John T Says:
October 23rd, 2009 at 2:25 pm
Karim, DO the options have to be the same dates as in January 2010? I have some AUY calls Jan 2010 and 2011 that are in the money already. Is this when you would sell higher strike price ones? I have Jan 2011 $5 calls and also 2011 7 1/2 ones. Should I sell an equal number of calls for AUY at say $15?
That part is still unclear to me.

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Werner Says:
October 24th, 2009 at 8:05 pm
Do I miss something here?
Step 1 ;you buy the $ 12.50 call options
Step 2 ;you sell the $ 15.00 call options against
the $12.50 ones.
Question!
Don’t you have buy the $15 calls before you can sell them?

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kers Reply:
October 26th, 2009 at 10:08 am
NO. selling a call just requires you to have the underlying shares in your brokerage account should u be called to deliver, OR suitable margin money with the broker.

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Tony DiRienzo Reply:
October 26th, 2009 at 12:07 pm
Kim, I read your articles and have been a 400 team player for a couple of months. I have drys in play right now and I’m waiting for another trade recco with a lower strike like the 7.50 and 12.50 strike leap spread already in play, however, instead of buying the 12.50 call leap leg of the spread, I sold it to take money in so I am limited on my upside gain. What can I do now to enhance this or change my current 2011 leap strategy? Also, do you have any current lower strike credit spreads I can put into play now (always X 10) contracts? Please advise. I’m trying to cover my subscription fee before I can make a profit and move forward.

Tony D

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MICHAEL Says:
October 27th, 2009 at 3:19 am
Hello Mr.Karim rahmtulla,
I am J.Michael Jacob from india i found your article very good enough, but i dont know much in options. could you explain this in any indian options contract.
I am ready to invest but i lack knowledge so could you you help me.

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