Spreads

 

We receive many emails from newer members who say their broker won't allow them to sell naked options, or that they require tens or hundreds of thousands of dollars in the account in order to do so. Well, there is something that you can do which will allow you to participate in these types of trades without the same margin requirements. One way is to execute spreads. Simply, you sell a put, then buy a put at a lesser strike price. What that does is eliminate the risk of a total collapse. Your total risk is the difference in the strike prices, and with every broker I've ever known that is all the requirement necessary.

Let's walk through one. Now this can get complicated if this is the first time you've ever done it, so you may have to read this 2 or 3 times.

Let's use Dell Computers (DELL) as an example. A few minutes ago Dell was trading at 91 13/16.  Several strategies using options can be employed if you think Dell is going higher. Of course, you can buy calls. For the calls to make money, it has to go high enough and soon enough for your trade to be profitable. You can sell naked puts, and if the stock remains above your strike price you keep the premium. You would be at risk if the stock totally collapsed, and that's why brokers have restrictions. So to eliminate that risk, you can open a spread.

Dell's at 91 13/16.  If you think Dell will close above 90 on expiration date, you could execute a spread similar to this. Sell the Feb 90 put, and buy the Feb 85 put. This is known as a credit spread, also referred to as a bull put spread.

1.  Sell the Feb 90 Put for 4 3/8 (That's the bid price. That's all you'll get when selling) You'll collect $438 for the put that you sell. 2.  Buy the Feb 85 Put for 2 3/4 (That's the ask price. You'll have to pay ask when you buy) You'll pay $275 for this put. So your net, or credit, is calculated   $438 - $275 = $163 So you have the potential to earn $163 in this trade by selling and buying one contract. Your margin requirement is $500. That's the difference in the strike prices. That's the absolute most that you can lose on the trade. If your broker requires more than $500 to execute a 5-point spread, fire him!  Your total risk would be $500. No one should require more than that, and I'm sure they don't. Further, if your account is set up to buy options at all, you should be able to open spreads without filling out any other forms or anything else. So you can participate in selling of puts without selling naked puts.

Now, what can happen in this trade? First, if the stock goes higher or at least remains above 90 on expiration date, then both puts will expire worthless and the $163 credit you received is yours to keep. There's nothing to do, no need to call your broker or anything else. They'll just expire and the money stays in your account. How much would you have made? You would have made $163 on a $500 investment. What?!!! Yep, your broker requires $500 in your account to collect $163. Do the math --- $163 divided by $500 = 33%.  Thirty three percent for about a month's trade. Do you see how selling puts and spreads can be lucrative? Many traders prefer selling puts to writing covered calls. I do both.  Now I have left out one thing... the commissions. And yes, you will be charged 2 commissions. One for selling the put, and one for buying the other put. So you do have to consider commissions in here. If you were trading just one option, then the commissions might cut in to your profits so much that it's not worth it. But if you were selling 10 then you can see how it gets
better. You'd collect $1630 on a $5000 cash requirement in your account. Now commissions don't take such a bite.

Now the down side... Let's say the stock tumbles.... going down, drops below 90, keeps dropping, goes to 80, keeps going, drops all the way to zero. What happens? You close out the trade. The 90 Put that you sold is biting you in the butt, but the 85 is your salvation. Whatever you have to pay to buy back the 90, is offset by the 85 Put, less the 5 point spread. So your total loss can only be 5 points.

If this is all new to you, then paper trade some spreads and get the feel for it. If you trade online, the first time you execute a spread, call your broker on the phone and get him to open the trades for you. You want to make sure that you open and close both sides of the trade at the same time. Otherwise, you could get caught "naked".

BULL CALL SPREADS (debit spreads)

We get emails asking us to compare Covered Calls to Bull Call spreads. Some folks are looking for a way to implement something similar to a covered call trade, but without having to invest a ton of money to buy some of these high priced stocks.

Call spreads can be an answer. There are similarities in the two as well as some important differences. First, they are both bullish positions, which sell a "covered" call, either for added income, or to be able to get into the trade with less money. When selling a covered call one buys the stock
(frequently using margin) and sells a call option for additional gains.

When entering a bull call spread, you buy a call at a given strike price, and sell a call at a higher strike price. The call that you sell is "covered" with the call that you bought. Some of the best stocks are rather high priced stocks and many investors just don't want to dish out that much
money for the stock, so they seek an alternate method of accomplishing the same thing. Sometimes a Bull Call Spread is the answer.

COVERED CALLS

Let's take a high-flyer stock like Yahoo. In this example we are bullish due to the upcoming earnings announcement on April 7. The stock closed today
(March 18, 1999) at 175 5/16. If we wanted to buy 100 shares of the stock and sell a covered call it would cost us $17,531.25, less the amount we would receive for the call. If you are lucky enough to be able to buy Internet stocks on margin, then your initial cost will be less. Many brokers have recently placed margin restrictions on internet stocks.  If you decide to sell the at the money call, the April 175, you would receive an $1,800 credit. If Yahoo's stock remains at or above 175 by April 16, you make an $1,800 profit on your $17,531.25 investment, or 10.6 percent. Not bad, but it takes a lot of money for this trade.

BULL CALL SPREADS

Now let's look at how we could use a Bull Call Spread to play the same earnings announcement. We'll use the $1,800 as our profit goal. We would buy April 175 calls and sell April 180 calls to complete the spread. Our cost for the 175s would be 18 ½  points for each, or $1,850. We would receive 15 7/8 or $1,587.50 for each of the 180s that we sell. So the debit spread is 2 5/8. That's what our broker is going to take out of our account when we open this trade. We then own (long) the 175 call and we're short (we sold) the 180 call.

The cost for one spread would be the difference between the option we buy ($1,850), and the amount of credit we receive in our account for the option we sell ($1,587.50) or a debit of $262.50. That's debit! That means your broker will debit your account for the $262.50 (plus commissions). There isn't a margin requirement per se. You're buying something and selling something. You need to execute both sides of the spread simultaneously. What's the worst thing that can happen? The stock could drop below the strike price that you're long, and both options would expire worthless. What would you lose? The difference in what you paid for the long option and what you received for the short option, or $262.50. So yes, you can lose your entire investment, so you must be bullish to enter this kind of trade. The profit potential for each spread would be the $500 difference between the strike prices minus the amount we paid ($262.50) to open the spread. So our profit potential, if the price of Yahoo closes above 180 on April 16, is $237.50.

If the Bull Call Spread is successful, it will net $237.50 for for a $262.50 investment. Now that's nearly a 90% return!  To make the same $1,800 profit as in the Covered Call example, we would have to put on 8 spreads at $262.50 each. That's about $2100. Compare that to the $17,531.25. The Bull Call Spread does require Yahoo's stock to move above 180, while the Covered Call trade requires no movement at all.

Consider this, what if you bought the April 170 and sold the April 175. The debit spread is 3 3/8, with a potential profit of 1 5/8. What's your return? A whopping 48% if the stock price remains above 175.  Now how did we figure that return?

First, the difference in the strike prices is 5 points.
You'd pay 21 1/8 ask price to buy the Apr 170.
You'd receive 18 1/4 bid price for the Apr 175 that you sell.
So you'd be debited the differerence which is 3 3/8 ($338.00). That's what your broker is going to take out of your account.
If the stock is above 175 at expiration the spread will be 5 points (that is, the value of the option you bought and the option you sold will have a difference equal to the difference in the strike prices, or 5 points). You'd earn 1 5/8 points.  Well, 1 5/8 divided by your investmest of 3 3/8 equals 48%.

Now you do have to consider broker commissions. You will be charged going in and getting out. So a single spread might not be worth it, but if you opened several spreads, then the commissions don't take such a bite out of your profits.

You may have to read this a couple of times to grasp it. I realize that spreads can be difficult to understand. A great book on the subject is Larry McMillan's "Options as a Strategic Investment". It's a relatively cheap book and considered a classic. If you don't have it, you should get it. It's the best reference book on options I've ever read.

You can get it Traders Press Bookstore.

Well, you ask, if you can get these kinds of returns for spreads, why would any one sell covered calls? Remember, the higher the return, the greater the risk. Yes, you can get great retuns with spreads. But you also take on the risk of losing your entire investment. Of course it wouldn't be $17,000 if you made the trade mentioned above.