I talked about call options and how you can use it to increase your return. You can also follow Lenny Dykstra's strategy of buying deep-in-the-money call options. So sticking with the options theme this week, I want to mention one of my favorite option strategies, the Bull Call Spread.
It's better to use an example to explain the Bull Call Spread strategy. I mentioned I like Motorola (MOT) stock at $18 and it should go to $25 within a year or two. Currently the call option on MOT strike 20 expiring Jan 2009 is $2.05. Now let's say you bought 1 contract. It will cost $205 (plus commissions, of course). That's the premium you have to pay and it moves lower as time approaches closer to the expiry date if the stock doesn't appreciate in value. With the Bull Call Spread, here's how you lower your risk.
Because you bought 1 call MOT strike 20, you can sell 1 call MOT strike 25. Currently the call option on MOT 25 expiring Jan 2009 is $0.65. By selling 1 call MOT strike at 25, you pocketed $65 to your account (less commissions, of course). That's right, someone actually gives you money. You become like the casino operator. That means your total risk is $205 - $65 = $140. Your maximum reward is between the 2 strike prices (25-20 = $5.00 ($500)). Your maximum return can be 257% return (($500 - $140) / $140).
Bull Call Spread Disadvantages
-You spend more in commissions.
-Becomes more complicated so you have to know what you are doing.
-If the stock goes up, you return is not as high as buying just a straight call option.
-If the stock continues to soar beyond $25, you still only make the maximum $500.
Bull Call Spread Advantages
-Less capital outlay so your risk is lower if you are wrong in your prediction.
-If the stock goes down and you are confident in your prediction, you can close your higher strike sell call position and then sell it again when the stock goes back up. For example, if the MOT stock goes down $2 to $16 and the premium for the MOT strike 25 is $0.30. You can buy 1 contract at $30 and close that position and profit $35 since you original sold it at $65. If MOT stock goes back up $2 the next day to $18, you can sell the higher strike call again and pocket $65.
How to make money with call options
Options can increase your return a lot faster than stocks but are more riskier. So like speculative stocks, it should be only a small portion portion of your portfolio.
For a more detailed explanation, click the link below.
Options 101
When I buy options, I go for the LEAPS (expires in 1 or 2 yrs), although I pay more of a premium, it allows the stock enough time to move in my favor.
For example, I like Motorola (MOT) stock due to Carl Icahn & Eddie Lampert's buys but it's not a long term buy for me (my definition of long term is like 5-10 yrs). Because MOT is in a competitive environment and when technology can change in a hear beat, I prefer to buy the option if the premium paid is reasonable. With MOT stock at $18.00, I consider it a turnaround value stock play with the potential of going to $25 within 1-2 yrs. If I buy 100 shares of it, I'll make only 39% return on investment ($700 profit) if it goes to $25.
However if I buy a one, Jan 2009, 20 strike, call option, I pay only $210 premium. If it goes to $25, my return will be 138% return on investment ($500 profit). If I buy 2 options, I make $1000 profit (less commissions, of course)!
What's the downside if the stock stays at $18 in 2 years?
If you bought the stock, $0 gained/loss. If you bought the option, expires worthless and you lost $210.
What's the downside if the stock goes to $15 in 2 years?
If you bought the stock, $300 loss. If you bought the option, expires worthless and you still only lost $210.
What's foolish is if you used all $1800 to buy options. What's prudent would be to buy 1 contract and keep the rest in cash to yield interest or use it as a reserve. Money management is the key to options trading.
Here's another example of buying a call option compared to the stock. Recently I bought one call option on Walmart, Jan 2009, strike at 50, for $440. At the time, the stock was at $47. Now the stock is up to $49.50 and my option is worth $610. That's a 39% return ($170 profit using $440 capital). If I bought 100 shares, my return would only be 5% return ($250 profit using $4700 capital).
If you've never played options, start slowly...... Also just like stocks, buy in stages and in wide scales. And because options can expire worthless ....it's better to just sell it when you've got a quick profit. I may sell my Walmart call option pretty soon.
Oh by the way, it's good to compare options with the same price stocks so you don't overpay. At the time, Best Buy's similar call option when it was at $47 was at $6.00 vs Walmart's $4.40. (I guess people are more bullish on Best Buy).
