Options strategies - call spreads

[Grieve]

It’s entirely likely that no-one will care about this except me, but I already crunched the numbers for myself, so posting in case anyone is interested.

My take on investing is, if you buy a stock, you think it’s going to go up. I guess you could just be in it for the dividend yield and not care if it goes up, but for the most part…if you invest, it’s because you believe in the stock.

So if you believe it’s going to go up, you want to make the most money you can from that rise (biggest percentage return), while putting as little of your money at risk as possible. That’s why I got interested in options, although it’s only recently that I got into more complex option products.

So you want to invest in a stock. I’ll use Apple as an example, but this all applies to any stock you like.

First out, you can buy the stock. It’s easy to understand – if the stock goes up 20%, the money you put in goes up that money. If it goes down 20%, so does your investment. Let’s say I buy 30 shares of Apple, for about $10,000. If the stock is up 20% after a year, that’s $2000 I’ve made, but it’s a lot of money to tie up for a 20% gain.

Then there’s call options. I can buy a single $240 January 2012 option for about the same amount, $10,000. Due to leverage, if the stock goes up 20% I’ll actually be up more than 50% ($15,200 value). If the stock goes up 50%, I’ll be up 152% ($25,000 value). That’s a better reward, but if the stock falls 20%, I’ll lose almost 80% of my investment. If it falls 30%, I lose everything.

So recently I’ve been using call spreads instead. That means buying a call a year out, and then selling a call for a higher value (I use a $30 difference for Apple). So if I buy a Jan ’12 $290 call and sell a Jan ’12 $320 call, the net cost to me is $1693. If the stock ends the year below $290 (down 11% from now), I lose all my money. But then, if I owned $10,000 of the stock and it dropped 11%, I’d also have lost $1100. If the stock dropped 50% I’d have lost $5,000 if I owned stock, but I can never lose more than $1693 with the call spread. So I’m risking (and tying up) less.

On the plus side, if Apple finishes flat for the year, or even down a couple of percent, I can sell my spread for $3000. I make a 77% return even if the stock does nothing – not too shabby. However, if the stock goes up 50%, I still only make that 77% (which of course is still a higher return that I would be getting owning the shares).

If you think the stock will perform well, you can go for higher strike prices for less money. I can buy a $325/$355 spread for $1305. If the stock ends the year below $325 (less than it is now), I lose my $1305. If it finishes at $355 (about 9% higher) or more, I can sell for $3000 – a 130% return. So, 9% return on owning the stock, vs 130% with the option.

If I’m really bullish I can buy a $400/$430 spread for $608. If the stock ends the year below $400 (which would be 23% higher than now), I lose my $608. If it ends above $430, I sell for $3000 – almost a 400% gain. So…I can never lose more $608, even if the stock goes to zero, but I can make a 400% return (vs 32% on my owned stock, which is risking $10k if the stock goes to zero).

Anyway, spreads seem like a pretty good idea to me. I’ve bought a $320/350 Jan ’12 spread on Apple, a $100/$120 spread for FFIV (after its 20%+ drop), and I’m planning to convert my POT and SBUX calls to spreads. So I guess I’ll be the guinea pig for the strategy.

Here’s a table showing how it would work out in various scenarios for Apple stock over the next year (bear in mind the average analyst target is $413). Also, you don’t have to wait a year to sell these. If you are well up anytime in the year, you can sell them then.