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Joe Cusick entered the option markets in the early 1990s, working his way up through three different exchanges to become a market maker on the floor of the Chicago Board Options Exchange until 2001. Joe took on the role of senior market analyst and senior vice president of education for optionsXpress, passing along his knowledge and analysis of the markets through his frequent contributions for CNBC, BNN, and Bloomberg.
To some investors, the word "option" is not typically welcomed with a warm embrace. But with the ever-changing landscape of investing, options are now more mainstream with investors and managers alike. Many investors are feeling the pressure for their portfolio to perform because of upcoming events like buying a home, car, paying for school, or retirement, and in response the industry is constantly rolling out new exchange-traded funds or new technology that makes it easier for you to manage more and more of your investments.
So strategically, how does an investor meet the demands of performance and find more ways to implement the market research and opinion without extending their risk capital? This is where the option product enters. Options make it possible to target a variety of investment objectives, while potentially reducing risk and increasing income.
This article aims to show you one such strategy, ratio spreads, to potentially do just that. At this stage, your head might be spinning and you might be wondering how to use options or options spreads like the stock repair strategy to limit some risk. Well, I intend to show you how, and don't worry: Your head will not spin off.
This stock and option strategy is designed to help compensate for a losing or flat long stock position, something that has pulled back 5% to 10% or has been in a consolidation for weeks or maybe months. Before we go any further, we need to define spreading. The term "spread" is often loosely used, but in this case it means that the strategy has multiple investment vehicles, both options and stock.
So how would one go about structuring such a spread trade? Let's take a look at an example where we purchased stock at $50 and the market has pulled back to $40, we want to hold onto the stock and we are not interested in cost averaging (buying more at a lower price) because we do not want to use any more capital on this trade, what can we do? First, buy a bull call spread.
- Let's hold the 100 shares of stock XYZ and buy the 40 strike call for $3 or $300 per contract and simultaneously sell the 45 strike call and receive $1.50 or $150 per contract (this is our bull call debit spread).
- With this bull call spread strategy, we only have $1.50 or $150 of capital risk, and if the stock goes to $45, we will make a $350 potential return. This is an important point: By selling the 45 strike call, we are removing some of the risk of purchasing the 40 strike call, but we are also limiting the potential profit from the 40 strike call.
- Also, if the stock stays at $40 or decreases in value, we still lose $1.50 or $150, and we want a strategy that does not add capital risk.
To address that last point, sell another $45 call against the stock that you already own. We combine the original stock purchase with the bull call spread discussed above to form a covered call, and overall, the combined covered call and bull call spread form a ratio spread strategy:
- We are long 100 shares of stock that is currently trading at $40 (a $10 unrealized loss), then buy one 40 strike call for $3 and sell two contracts of the 45 strike calls for $1.50. By doing so, we initiate the options position for no cost, paying $3 for the 40 strike calls and receiving $3 for selling the two 45 strike calls (3-3=0, seems simple).
- This is the important part of this strategy -- our new break-even point for the stock and option strategy is $45. If the stock rises to $45, we will make $5 on the bull call spread and $5 on the covered call, thus a profit of $10, which makes up for the original drop in the stock from $50 to $40.
- This will not reduce risk. So if you are bearish on the stock, do a different trade, maybe a protective put.
Another question that may arise as we look at the structure of this trade is, are we naked options? The answer is NO! We are long 100 shares of stock that matches up with one of the short 45 strike calls (a covered call, thus how I came up with the title) and the 40 strike call we bought is covering the other short 45 strike call (that portion creates a bull call spread). Ideally, you want to initiate this type of option trade for a credit or even money (no cost), or in some unique cases a small debit.
With any strategy, there are drawbacks, and in this case there are two specifically. (1) Profit is limited to the strike price of the option that is sold. (2) You won't realize your complete break-even right away. But there are ways to overcome the drawbacks. (a) Sell the spread early if the stock rises, taking early profits. (b) Collect the premium if the stock continues to drop. (c) Resell the premium for the original price if the stock price rises again.
Consider using this strategy if you are still slightly bullish on the stock, plus forecast that the stock will close at or near the higher strike price at expiration. As always, there are trade-offs. First, you must be willing to give up any profit above the higher strike price. Second, this is not a trade to reduce the long stock risk. This will enhance profit only if the stock increases in value, and if you are looking for income in a flat market, a covered call could potentially be a better fit. Hope this was helpful, and always feel free to contact our team with any question or considerations.