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Using Spreads to Buy Options at a Discount |
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By Ken Trester |
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One lower-risk way to play the stock market is to
buy long-term options that don't expire for several months or more.
A long-term option can be an excellent surrogate for the underlying stock and allows you to participate in the action of the stock for a lot less risk. Time is a key to success when you buy options. Long-term (LEAP) options buy you a lot of time, in some cases more than two years. And stocks can make gigantic moves over this time period. The major problem with long-term options is that they are usually quite expensive. One way to get around this higher cost is to use a vertical debit spread. A debit spread involves selling an option to offset some of the cost of the option you are buying, but still has the same limited risk as if you had simply bought the option. The word "spread" seems to scare some options players, but a debit spread is quite simple. For example, in early 2003 we recommended a long-term play on Texas Instruments (TXN) when the stock was at 17. The recommendation was to buy a TXN Jan 2005 25 Call. To offset some of the cost of this long-term option we also recommended selling a TXN Jan 2005 35 Call at the same time. This created a “vertical” debit spread and reduced the cost of the TXN 25 Call to 2 points ($200). Your total risk with this position was the cost of the spread, 2 points. From a risk standpoint, opening a debit spread is exactly the same as buying an option. But unlike buying an option, your potential profit with a debit spread is limited. Once the stock crosses the higher strike price, the gains from the option you bought are offset by losses from the option you sold. In our example, once TXN crosses 35, the gain in the TXN 25 Call will be offset by a loss in the TXN 35 Call. The total profit potential with a debit spread is the amount of the spread minus the cost of the spread. So for the TXN spread the total profit potential was 8 points (35 minus 25 equals 10, minus 2 equals 8). But keep in mind that your maximum risk with a debit spread is also limited, to what you pay for the position. With the TXN debit spread that was 2 points. So the potential return was 400%, and there was nineteen months remaining for the stock to move when we made the recommendation. Debit spreads usually don't generate maximum profits until expiration or the options move deep in the money (in our example, if TXN moves well above 35). So if the spread generates a 100% gain in the first few months, it is a good idea to close half your position and take some money off the table. In fact, that is exactly what happened with the TXN spread. The stock was very strong and the spread more than doubled in value. Our subscribers were able to close half their position and recover their initial investment cost. They then waited for possible future gains using the “market’s money.“ If the stock moves against you in a debit spread, another good tactical move is to buy back the option you initially sold if it has lost most of its value. Then you will own the long-term option without the profit limitations of a debit spread. For example, if TXN fell instead of rallied and the 35 Call fell to a couple tenths of a point in value, you could buy that option back and then own the TXN 25 Call with no limit on possible gains. Debit spreads might sound confusing to new option
players. But once you become familiar with how they work they likely will become
one of your favorite trading strategies. For a video on profitable option spread trading click here. |
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