Boca_Bobby Basics

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Options Talk-N-Trade (Options TNT) #4

In our last post we gave an example of a new strategy, a basic spread. We discussed how it can be used to reduce risk even further so that we can still take a position in a given equity. This idea of using even less capital to take advantage of a move in the PPS of an equity, is one we tend to use a lot. Why risk more than we need to take advantage of any possible gains? Well, there is a bit of a downside.

Although we risk less capital, we also limit the amount of profit we can get as well. There is always a catch, right? Let’s exam more of what we are really doing with the basic spread. First, we need to understand that there are two “legs” to our position. The first leg is the Call we bought. The second leg is the Call with a higher strike price that we sold. This is what we did:

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!)

The Call we bought with a $30 strike price, gives us a right to buy 100 shares of XYZ Company at a PPS of $30.00. But what if the PPS of of XYZ Company goes to $37.00? Uh oh, someone that bought the $35 Call from us has the right to buy 100 shares of XYZ Company at a PPS of $35.00! Let that sink in folks……

This can really drive you crazy if you’re gonna worry about someone that has the right to purchase shares that you really don’t own. But let’s assume that you really have enough capital in your account to cover any disaster that you think this created. First you would exercise your right to buy to 100 shares of XYZ Company at a PPS of $30.00. You then immediately turn around and sell those 100 shares to the person that bought the Call contract that gave them the right to buy 100 shares of XYZ Company at a PPS of $35.00. We make a $5.00 profit per share. Correct?

Well that’s the exact limit of our possible upside in profit. Do we really need to go through this long process to figure out this whole mess? If we did my friends, I’d just throw up my hands and say, “forget it, I’m going back to penny stocks!” LOL…. But fear not friends, there’s an easy way. Simple take the difference between the two strike prices:

$35/Calls - $30/Calls = $5.00 ……Viola…….

In review, we see that we risk $1.25 (our cost of the spread). And we limit our upside profit to $5.00 (the difference between the two strike prices). Please take time to really read talks #3 and #4. We use this strategy a lot and you really need to know what you buying. Remember, it’s your money, know exactly what you’re investing in!