Blaine561’s Blog

After reading Options 101 - From Theory to Application, I felt ashamed. I had erroneously accepted the fact that I understood what options were all about. Fortunately, I “saw the light” before abandoning the most interesting and flexible investment vehicle available-the stock option. Now, my strategy is still basically the same-buy low and sell high- but the methods are like comparing Homer Simpson with Henry Kissinger. Doh!!

As a result of Bill’s tutelage, I now purchase vertical option spreads when I see a high probability bullish scenario. Here’s how it works. First, look for an in-the-money call option that has a delta of at least 85%. That means an option that will mimic the move of the underlying stock by at least 85%; if the underlying stock moves up $1, the in-the-money call option will move up at least 85 cents. You see, knuckle draggers, an out-of-the money call option may be a correct selection but the option may move only a small fraction of the amount of the underlying stock. Now comes the cool part….once you secure your in-the-money-call, you sell (write) an out-of-the-money call. The premium provides an offset for the higher costs of purchasing the in-the- money call. The caveat is that you buy and sell in the same expiration month but at different strikes.

For example, suppose you think Home Depot (HD) will go up in the next 60 days. You would purchase an in-the-money call with a delta at least above .85. Currently HD sells for $29.20. The $20 Jan 08 Call option has a premium of $9.10 per share and a delta of .99; that is if HD moves up $1 so will the premium for the $20 call. You now have effectively substituted the call for the actual stock but at less than half the cost. (to purchase 200 shares of HD would cost $5,820. Purchasing two of the $20 in-the-money high delta calls costs $1820). Now to help reduce the cost of the call options, the trader will sell two $30 out- of-the-money call options (always try to sell as close to at-the-money as possible) for a premium payment of $1.05 per share. That would help offset the call premium by $210 for a net position cost of $1610.

If the HD moves up to $32 before being called away, you would have a profit of: ($32-$20) x 200= $2400-$1610= $800 net of commissions or an ROI of 49%. If a trader had just purchase the $20 call you would have had an ROI of 43%.

Let’s say that the stock doesn’t move and is at $29 at expiration. That means the option trader would have had a profit of ($29-20) x200-$1610= $190 net of commission or an ROI of 11.8 %. If the trader hadn’t sold the out-of-the-money call option, the trader would have had a loss.

When an option trader sets up a vertical spread, this is an immediate indication that the trader understands enough of stock option theory to at least play in the arena. If you are trading options and don’t understand how spreads work, you are best to step back and purchase some education like Bill Johnson’s Options 101 - From Theory to Application. (currently # 1 at Amazon).