So I mentioned call spreads a few times in my last few posts. What are those you might be asking? As I mentioned in my earlier posting titled Options are a Viable Option Right Now, options were created to reduce risk. Call spreads and put spreads (sometimes called vertical spreads) are the next step.
When options are referred to, they are referred to in one of a couple ways. They are either “in the money” or “out of the money.” As you can probably guess, “in the money” means that the stock has intrinsic or real value (i.e. a $25 call when the underlying stock’s market price is $28.) An “out of the money” derives its’ only value from the time value (i.e. a $50 call when the underlying stock is valued at $46.)
We have talked about buying calls and puts. Today we will move into the category of both buying and selling calls of different strike prices at the same time. So the call spread is buying a call close to the money and selling a call further away.
For example:
A stock is currently valued at $25.92. The JAN $27.50 call price is priced at $1.30 while the JAN $30 call is valued at $0.55.
Wait a minute….I thought you said that options are in $5 increments only? Mostly true, most stocks offer $2.50 increments up to $30 or $40.
So back to the example, I will buy 10 contracts of the JAN $27.50 for $1.30 and sell 10 contracts of the JAN $30 for $0.55 at the same time. So purchasing the call would cost me 10 contracts x 100 shares per contract x $1.30 for each for a total of $1,300. At the same time, since I am selling the JAN $30, I will receive 10 x 100 x $0.55 for a total of $550. So I pay $1,300 and receive $550 for a total cost of entering the trade of $750.
So let’s say the stock goes up to $30 at expiration, my $27.50 calls are now worth $2.50 and the $30 calls that I sold are worth nothing. I sell the $27.50 calls for $2.50 a piece for a total of $2,500, subtract my initial investment of $750 for a total profit of $1,750. That is a 233% return on my money. Not bad.
Now let’s say the stock goes to $35 at expiration, my $27.50 call is now worth $7.50 each, but my $30 call that I sold is worth $5.00 a piece. So I sell my $27.50 calls for the $7,500 and re-buy my $30 calls for $5,000 for a difference of $2,500. I then subtract the $750 that it cost to enter the trade for the same return.
If the stock stays at or below $27.50, then both the calls I bought and sold expire worthless, and I lose my $750.
If the stock expires at $28.25,then my $27.50 call is now worth $0.75. So after I sell my $27.50 calls for $750, I do not make or lose money on the trade.
The Pros: If the stock goes in the direction that I think it will go, I make a great return on investment. My bottom line on a $2.50 call spread (what I explained above) is that I will risk $0.75 to make $1.75. On a $5.00 call spread (say buying the $25 and selling the $30,) I will risk $1.50 to make $3.50 if the stock goes the way I want it too. The other big pro, I limit my risk by recouping some of my initial investment.
The Con: If the stock goes a long way in the direction I think it will, I limit my upside to either $1.75 or $3.50 depending on whether I buy a $2.50 or $5.00 call spread.
Again, these are more advanced options investing. Many brokerage firms will not allow beginners to do these trades because they think they are too risky. Why? They do not understand the nature or original reason for options. The trades are also sometimes hard to find, but they too are out there. Good Luck!

Internal Tags: 

Related Posts:

  • Put Spreads
  • More Option Basics and the Covered Call
  • How I am Making Money on Options Right Now
  • Bond Yield Definition
  • Options are a Viable Option Right Now!
  • Texas Electricity Rates
  • Futures

  • Like this article? Subscribe to my RSS feed.