A how to.
music selection: “Suddenly” — Billy Ocean
A great way to use options is with net debit spreads. These combine the leverage of long contracts with the income of short contracts. They play both ends against the middle to create a hybrid instrument with defined risk, lowered cost of entry into a trade, and great profit potential. I am going to demonstrate a Bull Call Spread on Apple (AAPL).
Say you are bullish on Apple (AAPL) and want to earn some short term profit with only a few hundred dollars at risk. You can buy one call of AAPL and sell another at a higher strike to capture the spread between the strikes. The strikes could be out of the money if you want to try to knock it out of the park but I almost always go with both strikes in the money. This gives me some downside protection while still allowing remarkable earning potential.
With shares currently at 212.50, you might go two strikes into the money and select the 200 and 205 strikes for a Bull Call Spread. I’ll use the 20SEP2019 expiries for purposes of demonstration. You would buy the lower 200 strike (AAPL190920C00200000) for about 14.71. You would also SELL the higher 205 strike (AAPL190920C00205000) for about 10.84. It is important to use a “combo order” at your broker. This is an order that places both the buy and sell order simultaneously. Option prices can move quickly and attempting to ‘leg into’ the trade can leave you holding the bag.
What you now have is the legal right to buy shares of AAPL at a price of 200 dollars (100 shares per contract). You also have an obligation to sell AAPL at 205 (also 100 shares per contract). It should be obvious that if you buy at 200 and sell at 205, you keep 5 dollars in profit.
The five dollars gained do not come at zero cost however. Remember that we paid 14.71 for one contract and collected 10.84 for another. Our net price (known as the ‘net debit’) is thus 14.71 – 10.84 = 3.87 per share. So for 387 dollars, you control the right to buy 100 shares at the price (strike) of 200. This would ordinarily cost you 20,000 dollars but the option contract gives you a lot of leverage. So long as shares are above the 205 strike at expiry, you will also sell your shares automatically for 205 (20,500 dollars). Your 500 dollars in proceeds less your cost of trade of 387 is 113 in pure profit. These are prices that the contracts traded at today so you would be looking at a holding period of 30 days. Your return would be 113/387 or 29.2%. Over 30 days that annualizes to 355%!
Ordinarily, a single short contract at 205 would tie up 20,500 in margin. But because we played both ends against the middle and had a position that was fully hedged, we only consumed 387 in margin, which is the cash outlay. The 387 is the most you can possibly lose on the spread and that only would happen if shares were below 200 at expiry 30 days from now. Given today’s price of 212.50, shares would have to fall over 5.8% in a month’s time for that to happen.
I’ve had several emails asking about the mechanics of these trades so I’m glad to spell it out for anyone who is new to options. I’ll be back next Wednesday showing how to turn this trade on its head and bet AGAINST a company with a Bear Put Spread. And again the following Wednesday detailing how a Calendar spread works to leverage the gain you can get from exploiting the decay of time value versus selling a covered call or cash secured put. These are powerful tools that need to be in your toolbox. Until then…
Devour your prey raptors!