A case study in using vertical spreads
Chris McKhann | [email protected]
Buying options can be a way to get a leveraged directional play. Last week, for example, we bet that Apple would bounce. We could have bought the stock, but that is expensive. We could also have just bought a call, but instead we opened a May 405/425 vertical spread.
This means that we bought the May 405 calls and sold the May 425 calls, all as one trade. AAPL was just below that $405 level at the time, and it has since traded back above $440. That would be about $35, or a gain of roughly 9 percent, if you just owned the stock.
Our call spread gained only $10 from our purchase price, but we paid only $7--and it was worth $17 a week later, a profit of more than 140 percent. That is the advantage of the leverage of options.
But leverage does cut both ways. If AAPL had traded lower or was just sitting below $405, and we held the spread until expiration, we would lose our entire investment. That is why it is so important to keep the trade size appropriate to significantly limit our risk.
If AAPL had traded back down to the low of $385 from two weeks ago, you would have lost $20 in the stock trade. But you would still lose only $7 from the option spread, regardless of how low the stock went.
Some might wonder why we use spreads, and this is a good question. If you had simply bought a May call, your returns would have been even better; and in hindsight, that would have been a good trade. But that is usually only the case when the stock runs sharply up through the further strike that you use, in this case the $420 level. In essentially all other cases, you are better off using the spread.
Our spread reduced the cost of the trade by about 30 percent. That means less capital outlay and less risk in the trade. It also means that we have a greater probability of profit, and that is the real key to success in options.
(A version of this article appeared in optionMONSTER's Advantage Point newsletter of May 1.)