Speculating with options can be fairly straightforward — you buy a call option when you project that a stock is going up, or you buy a put when a stock looks like it’s going to go (or keep going) down.
If you’ve gotten the hang of buying options, you might be looking to expand your knowledge and use of more-advanced strategies. And you don’t have to be an advanced or even an active investor to add more trading tools to your arsenal.
There are two strategies that are nearly identical to buying calls and puts, but they will cost you less to initiate and they can limit your downside risk. And all it takes is one extra step to initiate these types of trades.
If you’re comfortable buying a call option, you can take the next step and instead establish a bull-call spread the next time you want to use options to play a stock to the upside.
Bull-call spreads mean buying an option at a lower strike price and selling a less-expensive option against it. So, you get a credit for the short position but you still pay more for the long position.
For example, with ABC Corp. trading at $22 per share, you can buy the ABC 22.50 Calls as a bet that the stock will jump at least 50 cents during the life of your option.
But what if you’re thinking that this is a stock with a lot of momentum, one that can even go to $25 while you have this trade on the table?
It’s one thing to expect a stock to rise by 50 cents, but maybe a $3 jump would be challenging to achieve in an unpredictable market.
If you’re convinced that the stock is going to run up and keep running, your best bet is to buy that ABC 22.50 Call and stop there. But if you’re sure the stock is going to go up, but not sure by how much, you can take an extra step to buy that call for less money.
A bull-call spread is exactly what it sounds like — a bullish bet established by buying a spread, with a spread being a two-sided trade.
The first step is to buy that ABC 22.50 Call but, in a simultaneous transaction, to sell a call against it at a higher strike price.
You can choose any strike price you want, but don’t go too high because you’re looking to get a credit from the option that you sell.
Before we go any further, it’s helpful to know the terminology. When you purchase the ABC 22.50 Call to hold long in your trading account, you are “Buying to Open” the position. But when you sell a call against it — say, the ABC 25 Call, you are “Selling to Open.” Basically, you are “opening” two sides of a trade — you’re just buying one and selling the other at the same time.
This strategy helps you to save money on the long call. You may be OK with paying a buck or two per share to buy a call option, but many investors start to shy away from options when they get into the $4 or $5 range.
But let’s say the long 22.50 Call is trading for $4 — that’s money you pay to enter the trade. But let’s also say that the 25 Call is trading for $3. Basically, you spend four bucks to buy the long call and collect three bucks on the short call. You have now just spent one dollar to bet that the stock is going to trade up to $25 before options expiration.
Your profit is dependent upon the stock finishing somewhere between the two strike prices (in this case, $22.50 and $25). At the very least, you want the stock to go to $23.50, which is your breakeven point (that figure comes from adding the lower strike price of $22.50 to the $1 you paid for the spread). Anything above that, up to $25, is profit.
If the stock goes above $25, the bull-call spread limits your profits because your short call was, in effect, a bet that the stock wouldn’t trade above $25.
This is why you may just want to buy the call outright (and not establish a spread) if you think the stock will make a more-dramatic move, as the short call serves to cap your upside.
However, because all trades don’t work out (even though we wish they would!), your downside is capped, too.
What if the stock takes a huge tumble and goes to $20 — which is well-below your long call’s exercise price? Unfortunately, you’re out of luck because both options are now out-of-the-money.
The long call at $22.50 gives you the right to buy shares at that price, but if they’re only trading for $20 on the open market, the call — and, in turn, the spread — is worthless.
But to your advantage, you’ve only lost a buck (or $100 per contract) on the investment if the stock tanks. And that would hurt far less than losing the $4 that just buying the long call outright would have cost you!
Speaking of stocks going down, the bear-put spread strategy is a way that you can make a bet on downward trading movement.
And like its bullish counterpart that we just discussed, the bear-put spread can help you to save money on your put option trades, too.
Again, if you think a stock is going to make a significant drop, buying a put option may be your best bet. But if the pullback is looking to be a mild one, selling to open another put against it could help you to hedge your bet and limit your expenditure.
Just to review, with both the bull-call spread and with the bear-put spread, you will “buy to open” the long position and “sell to open” the short position against it.
The spreads work identically insofar as buying an option and selling one against it for a net debit — that is, paying more for the long option and collecting a bit less for the short option position.
The difference with the bear-put spread, however, is that the strike prices you buy and sell are the mirror image of the bull-call spread. Because the stock is going down, you buy the higher-strike-price option and sell a lower-strike-price option against it.
Basically, in either case the option you choose to buy might be near- or at-the-money, which means that the strike price is close to the market price of where the stock is trading. The option you short is in the direction in which you expect the stock to go — higher with the bull-call spread, or lower with the bear-put spread.
Let’s say that the stock made the run to $25 and you profited with your bull-call spread. But suppose the company is probably going to miss its earnings expectations in the next quarter, which could knock a few points off the stock when it makes the announcement.
You can buy the bear-put spread by buying the put options at the $25 strike and then selling the $22.50 puts against them. Let’s say you spend four bucks on the long $25 puts and collect three bucks on the short $22.50 puts. Essentially, it’s the same strategy with the same expenditure, but it’s a bet on the stock trading in a different direction!
Again, with the bear-put spread, you expect the stock to finish somewhere in the middle of the two strike prices. If the stock drops like a rock in a pond, the most you can make is the difference between the two strike prices, which is $2.50 ($25 – $22.50).
So if you bet correctly and the stock goes down to, or through, $22.50, then your spread is worth $2.50. Remember, you’ve spent $1 to initiate this trade, so this could translate into a 150% gain, as you put a dollar on the table and you can cash out with an extra $1.50 in your pocket on top of your original investment.
You can establish bull-call and bear-put spreads in most trading and retirement accounts because the combination of a long and short option in a simultaneous transaction carries a similarly low amount of risk as just buying puts or calls.
When unwinding a spread position, you just reverse the orders that you give your broker. The long option that you “bought to open,” you will now “sell to close.” And with the short option that you “sold to open,” you will now “buy to close.”
As you can see, you can spend a little less money to make the same types of trades you might already be making. These less-expensive trades may come at the price of capping your upside, but the tradeoff can be worth it if you don’t lose your shirt completely on a bet that doesn’t turn out in your favor.
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