Two Low-Risk Plays for Conservative Option Bulls
- Posted by Andrea Kramer
- on September 7th, 2011
The Dow Jones Industrial Average $DJIA is on pace to snap its streak of triple-digit drops today, as Wall Street waxes optimistic on the prospects for a new jobs plan from President Obama. Against this backdrop, what if you want to roll the dice on a stock you think is headed for a modest rebound, but don’t want the risk of a stock ownership or a straight call purchase? Have no fear — by employing one of these two-tiered option plays, borderline optimists can gamble on an uptrend without going all in.
First, let’s dissect the bull call spread. To implement this strategy, the investor would buy a near-the-money call on the underlying stock. While this in itself would be a “vanilla” option play, the speculator can further reduce the cost of entry — which represents the maximum risk — and the breakeven rail by simultaneously selling an out-of-the-money call with the same expiration date.
However, the addition of the sold call also eats into the potential reward on the play. More specifically, even if the shares skyrocket before expiration, the maximum profit potential is limited to the difference between strikes minus the net debit, no matter how high the security surmounts the sold call strike. For comparison, the maximum profit potential on a call purchase is theoretically unlimited, as there’s no limit to how high an equity can rally.
On the flip side, investors can also employ puts to bet bullishly on a stock. To construct the bull put spread, the speculator would first sell a put, with the strike correlating with the trader’s expectations for technical support. Or, for example, if the strategist expects Stock XYZ to remain north of $50 throughout the next few weeks, he’d sell a September 50 put.
Then, to reduce the risk on the trade, the investor would simultaneously buy a lower-strike put with the same expiration date. Again, though, while the hedge limits the speculator’s losses (to the difference between strikes, minus the net credit) in the event of a significant pullback, it also eats into his profit potential.
Specifically, the goal of the bull put spread is for both puts to expire worthless, allowing the trader to pocket the entire net credit received at initiation — which represents the maximum potential reward on the play. In other words, the more the investor pays for the purchased put, the less he stands to pocket at expiration.
In conclusion, both of the aforementioned spreads are great for traders who want to wager on a modest upside move from the underlying stock, but who don’t want to risk all of their proverbial chips in the process. However, since — as alluded to above — the goal of the put spread is for both contracts to finish worthless, it’s best implemented by using short-term options, which allow less time for the underlying equity to make a monstrous downside move.
In either case, it’s important to note the impact of “insurance” on your profit potential, which will eat into your maximum reward. In other words, true bulls may want to stick with the straight stock or call purchase, which would generate even heftier profits in the event of a significant surge.
For more options-centered educational content, or to see which stocks are heating up the options pits each day, visit my home base at SchaeffersResearch.com.
The information in this blog post represents my own opinions and does not contain a recommendation for any particular security or investment. I or my affiliates may hold positions or other interests in securities mentioned in the Blog, please see my Disclaimer page for my full disclaimer.blog comments powered by Disqus
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