Boca_Bobby Basics

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Options Talk-N-Trade (Options TNT) #3

In today’s post we’re going to discuss one of our first types of strategy. If you’re like me you just hate losing trades. I know that losing a trade is just part of the game. But something about them really cuts deep for me. So I am always looking for ways to lower my risk and therefore give me a higher probability of success on each trade. Winning trades just make this thing we do a whole lotta fun!

Yesterday we talked about the real out-of-pocket cost for buying a contract. I hope by now at least we can see that buying one Call Contract is much less money than buying 100 shares of XYZ Company. But here’s the math anyway.

100 shares of XYZ Company X $30.00 per share = $3,000.00

1 $30/Call of XYZ Company X $3.50 per contract = $350.00

Wow! That’s a savings of $1,650.00! And in essence will control the fate of 100 shares either way we play it. So a risk of a mere $350.00 would be a pretty good risk. Wouldn’t you agree? Of course, if our stock doesn’t move significantly higher than $30 before the contract expires, we risk holding a contract that may be worthless. Well, that’s not a good feeling. Is there any way we can still control the fate of those 100 shares for less than the price of a Call Contract?

Well yes there is. It’s a strategy I use quite often. It’s called a spread. It has pro and cons so we really need to discuss why we might want to use it and why we may not. The basic reason to use a spread is to reduce your risk even more by ultimately paying less for that $30/Call of XYZ Company. And here is how we do it.

When we bought that $30/Call contract we still have to pay the $3.50 asking price. But, there are many different Call Contracts for sale. If we look at the options page, we probably see call contract with higher strike prices. We may see $35/Calls, $40/Calls, $45/Calls and so on. Each of these strike prices also has an asking price. For example, the $35/Calls may be priced at $2.25 per contract. The $40/Calls may be priced at $1.00 per contract. The $45/Calls may be priced at about $0.30 per contract.

We can see that the higher strike prices have a less likelihood of being achieved so they have increasingly lower asking prices. If we think about it, this really makes sense. There will probably be less demand for these higher strike prices, thus they should have lower prices. It’s simple supply versus demand economics. But we can use this to our advantage. Let’s see if we can sell one of these higher strike contracts at the very same time we buy our $30/Call contract in all of our examples thus far.

So this is what takes place:

Buy 1 $30/Call of XYZ Company @ $3.50 ($350 comes out of our pocket)

Sell 1 $35/Call of XYZ Company @ $2.25 ($225 goes back into our pocket)
Our net cost for both contracts = $1.25 (only risking $125 on the trade!)

As you can see, we just lowered our out-of-pocket costs from $350 to $125! And we still control the fate of those same 100 shares of XYZ Company. Our risk has been reduced significantly! This is a great way to get into some trades you might ordinarily pass by. For example, take a look at the prices of some AAPL Call options. Those contracts ask you to risk a significant amount of capital. Using this strategy will help you lessen the cost of those contracts and still take advantage of any upside AAPL may have.

http://finance.yahoo.com/q/op?s=AAPL&m=2012-06

I will let you study this post before I go into it a little deeper. Happy trading friends…..