How to Use Option Spreads to Manage Risk
With trade tensions heightening once again, it’s been a difficult time for stock investors. One way to navigate through these rough waters is the use of options, which offer the flexibility to make money whether the market is up or down.
Seasoned option traders try to minimize potential losses, by using a combination of different options to hedge their positions. Let’s take a look at two basic strategies.
The Bull Call Spread
If an option trader expects a stock to rise modestly, he may take a bull call spread position, also known as a bull call debit spread.
The maximum profit in the spread is limited to the difference between the two strike prices minus the net cost of the spread multiplied by 100—each contract is equal to 100 shares of the stock. In the above example, the difference between the strike price is $5 ($60-$55) and the net cost is $1.70 ($2.80-$1.10), so the maximum profit is $330 per option contract: ($60-$55-$1.70)x100.
(For simplicity’s sake I ignore commission cost.)
Your return will be best when the stock price is above the short call’s (higher) strike price. If CSCO ends up at $62 on the expiration date, for example, you would make $700 from the long call but you would lose $200 from the short call, for a net gain of $500. However, you have to subtract the $170 net premium cost, so your net gain is $330.
The maximum loss occurs when the stock price is below the long call’s strike price and expires worthless. This means you lose the premium you paid. However, the loss is offset by the premium you received for writing the call. In the above example, your maximum loss would be $170—($2.80-$1.10)x100. If you had only bought the call, your maximum loss would have been $280.
The breakeven point is the strike price of the long call plus the net premium of the spread. Continuing the same example, if CSCO ends at $56.70 at the option expiration date, you would break even. The long call is $1.70 in the money and the short call expires worthless, so you make $170. But your net premium cost is also $170, so they cancel out.
The advantage of this strategy? The cost of the spread is cheaper than buying the call option alone and you reduce you maximum potential loss. The flip side is that you also limit your maximum potential, and doing an extra trade means paying an extra commission, but nowadays the commission cost is usually negligible.
The Bear Put Spread
The bear put spread, aka bear put debit spread, is essentially the opposite of a bull call spread, used when you think the price of the stock will fall modestly.
Continuing the CSCO example, to initiate a bear put spread, you could buy the October $50 put for $2 and write the October $45 put for $0.90. Your net debit is $110 per contract: ($2-$0.90)x100.
As in the case of the bull call spread, your maximum gain is limited to the difference between the strike prices minus the net cost of the premium multiplied by 100. This occurs when the stock price falls under the strike price of the short put. Your maximum gain in this example would be $390: ($50-$45-$1.10)x100.
Your maximum loss occurs when the stock price ends higher than the strike price of your long put and both options expire worthless. If CSCO ends up at $51, both the long put and short put expire worthless. Your total loss is $110.
The breakeven point will be when the stock is at $48.90, the higher strike price ($50) minus the net debit ($1.10).
The pros and cons of the bear put spread are the same as for the bull call spread. You reduce your maximum potential loss, and you reduce the cost of the trade and the breakeven point. The downside is that you limit your maximum gain.
In the simple examples I discuss here, we assume that the option positions are initiated at the same time and held until expiration. In practice, as the stock price fluctuates, an experienced option trader can adjust his position. For example, if he thinks it’s more profitable, he can close out the spread early, or he could close out the short leg of the spread and let the long leg ride (in this case, if things go right, the maximum profit could be higher than the spread).
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