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.

[Breand]

Interesting stuff, I'll have to research this some more.

I did a lot of studying up on LEAPs after reading in "The Big Short" how a couple of buddies made millions off it from starting with only 100k. Never had the guts to pull the trigger yet, and Sharebuilder seems to have a very confusing interface as far as buying some.

[Jakensama]

This is all too confusing for me so I just put my savings into buying the sack of magic beans.

[Grieve]

Breand, the interface in Etrade is confusing as well, took me a while to figure it out. Now I have it down pat, though. With e-trade at least, the key is to use a "net debit" when buying. That means you specify the maximum difference between the prices you will pay.

So if you are buying at call at $345 for about $42.90, and selling a call at $375 for about $29.60, you'd say to price it at a "net debit" of say $13.30. That means the broker will make sure you never pay more than $1330 per contract. To sell them you just reverse it.

I sold the first of my spreads today (for QQQQ), and it seemed to go fine. I've gone into it in a big way, now have spreads for AAPL, POT, MSFT, AMZN, SBUX, FFIV, INTC, HAS, QQQQ, and RBCN. Some are doing better than others, with POT really zooming up right now (thanks to Egypt).

[Vanraw]

FYI, I need to digest this as well. Just haven't had time. The one thing that I have been playing with is the leveraged ETF's. USing the 3x short and gain ETF's you can ply the spreads pretty well. If your in what you think is a relative flat market condition, you buy both at what you think is the medium. If you have to dump at any time your even money, but if you can play the channel, you win on both sides. You can also buy options against the ETF.

Mostly I'm playing this idea with spreadsheet fake money right now. I'm beginning to feel that we are going to be in a 2011 flat market channel with where we are right now near the bottom of the channel. Perhaps a over all 5% to 10% channel swing. When I look at the over all dow, and the History of its peak at 2008, I dont think we are going to see 14000 this year.

[Grieve]

I hope you are wrong, or my spreads could be a very expensive mistake. I need all my stocks to go up another 4-10% before the end of the year

[Vanraw]

Grieve, I'm digesting a bit of what you posted. It sounds like you are writing naked calls. I know you own Apple, but not sure about the others. Ive never dipped into writing calls or puts, but used options to "gamble" that a stock I dont own was going to move, or to protect a stock that I do own.

When you "Sell a Call" you are the writer of the option, and thus you now have to be able to cover it if the purchaser deems they want to execute the contract.

[Grieve]

I know it can seem that way, but in fact you are fully covered - no margin is needed. Let me give you a non-Apple example (cos I know everyone gets sick of Apple).

I bought a Jan 2012 $20 call on INTC (Intel) for $2.44, and sold a January 2012 $22.50 call for $1.28. That means I paid $1.16 ($116) a contract, and I bought 7 of them for $812.

The key here is that you match up a bought call with a sold call. You're right, if I still hold the call I sold on Jan 2012, and Intel has rocketed up to $30, I would have to provide them with 100 Intel shares. But...I wouldn't have to buy them at $30 - remember I also have a $20 call I own, allowing me to buy 100 shares at $20. As long as you hold both options to expiration (or sell them at the same time), you are completely covered.

The way it works is, assuming you hold to expiration (which I don't plan to), if Intel is under $20 at expiration, both the options are worthless. I lose whatever I paid for the spread ($812 in this case). That is the maximum I can ever lose.

If Intel is over $22.50, my call I own will always be worth $250 more than the call I sold. So I will make (for my 7 contracts) $1750 minus what I paid ($812) equals $938 - a 116% return.

If Intel is somewhere between $20 and $22.50, the gain or loss will be somewhere between those two numbers. My break even number is $21.16 ($20 plus the amount I paid per spread, which was $1.16).

And all that is invisible to you, handled by the broker - you don't actually have to physically deliver shares to anyone.

INTC closed at $21.57 yesterday, so I'm above my break even point. The stock has to rise 4.3% in the next 11 months for me to hit the full payout level ($22.50). So the stock rises 4.3%, but you make 116%.

The downside of course is that if the market tanks you lose whatever you put in. If it stays exactly where it is right now, I'll make a small profit on most of my spreads.

[Vanraw]

OK got you.

Your example brought up a question in my mind, not related to your example. Do you know what would happen if the writer of a call could not cover it? So lets say Joe Schmoe wrote a call for your example of intel, and someone bought them, the stock rockets to $100 a share, and Joe cant cover the call? He is broke.

Does the brokerage company cover this? or the buyer of the call get screwed?

[Grieve]

I don't think most brokerages would let you write a naked call without marginable securities to cover it. It's basically the same principle as shorting - if the stock you are shorting shoots up, you'll get a margin call from the broker...the classic cause of short squeezes.

Selling a call is really the same as selling short, except you are saying that the stock will not go up, rather than it will explicitly go down. So...if you sold $10,000 of $30 calls for Intel, the broker would have a similar calculation of how much cash and/or marginable securities you'd need in your account to cover it. If Intel starting rising in value, and so the amount that you would have to pay to cover the calls rose, the broker would force you to liquidate some stocks to raise enough cash to buy back the calls. In fact I think the broker can sell them without even asking you.

Now...if that happened for a company that got bought out (say), and shot up 40% after hours before you could do anything...I'm not sure what happens. I assume the brokerage would sue you for the difference, and try to take any assets you had. Brokerages usually have pretty strict margin rules - I doubt they'd even let you sell a naked call unless you had a lot of assets or cash in your account.

[Vanraw]

The big difference between a Short and selling a call though is that when you sell a call you are the writer of contract that someone else holds (not the broker), where a short is an outright margin agreement with the broker. At least that's how I understand it.

The main reason I was asking is I have made some good bets on buying calls. I was wondering if I would ever get burned from a contract writer that all of a sudden could not fulfill closing a bunch of poorly written contracts

[Grieve]

Progress on this so far, after 10 months...

Mixed bag. Started off great, but the big market swoon killed a bunch of my trades. Although almost all my spreads expire in Jan 2012, I sold some as the market went down. I also bought more while it was down.

Best completed trades so far
490% return on an Apple call spread
278% return on another Apple call spread
80% return on a SLV trade

Worst completed trades so far
-100% return on CSCO, RCBN, XOM spreads

Right now I'm holding onto several probably worthless spreads (Netflix, Silver, Hasbro, FCX, POT), and a bunch of profitable AAPL, GOOG, and CRUS spreads.

After being up 91.12% at one point (goal is 100%), I slipped to just 26% up, and just clawed my way back up to +70%. All depends on Apple now (I have 7 different AAPL calls spreads!). I guess as long as I beat the market I should be happy.

http://www.flickr.com/photos/68729380@N08/6244280382/

[Vanraw]

NICE!

[Slamz]

I've done well on AMZN. Made two good trades for +20% each over the past few months (they were 160 in March, now 246). Too chicken to hold it longer because I still feel like their p/e is bad (currently 108!) but they just keep going up and have consistently beat the DJIA. I'm going to keep an eye out for a good Amazon bubble-burst and probably get back into it again.

I was doing great on silver with several good trades for +20% (that's my line in the sand) but I got in again after a good sized crash, which was followed by a massive crash and now I'm underwater there. SLV's new channel is around 29-32 with pretty rapid fluctuation.

[Grieve]

It's been a wild ride (down -14% in June, up 82% a few weeks later, and then crazy volatility), but I finished up 54% for the year. Never hit my goal of 100%, but I can't complain considering how the S&P ended up.

http://flic.kr/p/b5k8Cv

[Vanraw]

Nice.

[amins]

If there's no clear direction (not trending) or a known channel, Iron Condors work extremely well for your "Flat Trades".

Just an idea.

As well, decent platforms for options that have "Virtual Trade Platforms": Options Xpress ; Options House.

You can also get the platform from Trade Navigator that will allow you to run simulators.

[Grieve]

Yeah, I've been thinking of looking elsewhere, I'm just used to etrade. It's pretty expensive for options, though.

I'll have to take a look at iron condors as well. Although my strategy has changed from "flat" trades to bets on stocks (primarily Apple) going up a lot. For those, vertical spreads work well, and are a lot cheaper than flat out buying calls (especially for Apple).

[amins]

Do you have a specific IV level you look for before deciding wheither to get in a trade (buy or sell) or the IV's relation to Historical Volitility?

The IV Crush absolutely demolished my account when i first started trading Calls / Puts and i haven't really gotten back into them. I do trade a 3-4 week Credit spread on the ETFs that mimicks the bonds, just becasue i watch those charts everyday.

[Grieve]

No, i trade purely based on "gut feeling". If I think something is undervalued, or has a lot of growth coming, that's all I base it on. Don't really try to time it, because most of my spreads are leaps.