LEAP Option Spreads: Tame the Market With This Risk-Blasting Strategy
Okay, let’s start with what I think are the facts…
- The stock market will remain volatile for the rest of the year.
- Europe is the key driving force behind this volatility and once the euro hits the bottom, it will signal that the crisis is nearing the end.
So with that said, you might be thinking, “Why not just wait until the end of the year to invest or until the euro has bottomed?”
If it were only that easy, I’d have retired to a tropical paradise many years ago!
What I can say is that if Europe gets its house in order, 2011 will present an explosive opportunity to make money. Until then, though, how do we translate the market’s 1%, 2%, sometimes even 3% intraday price swings into even greater profit swings for us? I’ll show you…
To Kill a Mocking Market
The market can be a humbling force for any investor, financial analyst, or writer. It often runs in the opposite direction than we predict, mocking our best judgment in the process.
And I’m not immune to making losing calls from time to time, regardless of what my marketing department would like me to say!
So whether the market rallies sooner than expected, or falls harder than expected, it’s important to have flexible strategies in place. Here’s a way to stay profitable or protected either way…
Low Dollar Risk… High Dollar Return With LEAP Options
The way we accomplish that is by using the old failsafe investment strategy – LEAP options.
Right off the bat, we reduce the amount of money that you’d ordinarily have at risk with a straight stock purchase by up to 90%. So we’re only risking 10% of our capital, with the maximum loss being 10% of what we’d pay to own the shares outright. That’s a far cry from a 25% stop loss… or worse.
Second, there’s a way of using LEAP options to reduce risk even further – and potentially enhance returns, too.
It’s called a spread play.
In a spread, your gains are limited to the difference between the two price points (i.e. the price of the options.) In return for this limited risk, the gains are also limited. Let me use an example to illustrate…
A Step-By-Step LEAP Spread Trade
Here’s the step-by-step process for a LEAP spread trade…
- Let’s say you have a stock at $20 that you think is headed to $30 by the end of 2012.
- You look at the $20 LEAP call options, which are for $4 per contract – 20% of the underlying share price. Stock market volatility has made them more expensive than usual. So how can you reduce that cost?
- The answer is to combine an options purchase and a sale, so that you offset the purchase price.
- You buy the $20 call for $4 ($4,000) and sell the $30 call for $2 ($2,000).
- Your net cost is now $2 per contract – 10% of the underlying share price. Remember, there are 100 shares in an option contract, so your actual net cost amount is $2,000.
- The profit potential is $8 – calculated by subtracting the net cost ($2) from the difference between the strike prices ($10). That’s a 4-to-1 return. On a 10-contract trade (equivalent to controlling 1,000 shares), that’s an $8,000 profit on $2,000 at risk.
Compare that to what the stock trade would cost. You’d pay $20,000 to make $10,000 – just $2,000 more in profit for $18,000 more in risk.
And what do you give up by slashing your risk? Well, you cap your gain. If the stock moves higher than $30, you get no more on your options trade, since you sold the right to buy the shares at $30 to someone else for that $2 premium you received.
And while the shareholder would have unlimited upside, holding shares in a volatile market can be risky business. Much riskier than it needs to be when you consider LEAP spreads.
Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the official position of Wall Street analysts.
About Karim Rahemtulla
With more than 20 years of experience, Karim has mastered the subtle art of options trading. What we admire about him is his ability to score huge gains while minimizing the massive amount of risk that often comes with options. Beyond his expertise in options trading, he is also the author of the best-selling book Where in the World Should I Invest? He publishes weekly about smart speculation in his latest free e-letter, Trade of the Day.