Thursday, April 19, 2007

How I Made 16% On A Stock That Went Down 9% Without A Margin Account: Part 2 of 3

Now that I established what options are, I will start to lay out a couple strategies using options and how you can achieve higher returns.

Bull Spread:
If an investor feels that the stock will go up, hence the name bull-spread, he/she can create a strategy to achieve gains, while capping losses using options. To do this the investor would sell a call (or put, works with both) at a lower premium and buy a call (or put, works with both) at a higher premium. The investor will be losing money at first, but the purchased call will not need much movement to be in the money. In the example below, the investor buys a call at a strike price of $40 for $3 and writes a call at a strike price of $45 for $1. If the future stock price is $40, the investor would lose $3 on his/her long position, and gain $1 on his short position. If the stock price were to advance to $42, the investor would only be down $1 (42-43) on his/her long position, but still up $1 on his/her short position (so even overall). If the stock price were to advance to the written call's strike price, the investor would be up $2 (45-43) on his/her long position and would be flat on his/her short position. Anything in excess of this price would still result in $2 of profits because each up-tick in the stock price would yield a $1 gain on your purchased call, but a $1 loss on your written call (the investor would exercise this call).

Bear Spread
The investor could take the opposite strategy by simply reversing the written and purchasing positions. This investor would sell the option at a premium and buy the option for cheap. The strategy would draw out to be something like this:
These are two of the most common option strategies. An investor may ask, if I was bullish on a stock and wanted to cap my losses and gains, why wouldn't I just set stop and limits? The answer is that this strategy is inherently cheaper than buying the stock and setting limits. Let's say the same investor that took the bull spread strategy decided to purchase the stock instead at $42. If the stock were to go up two dollars the investor would be up 4.76% ($2 gain/$42 paid). Now lets say the investor took the bull spread position. That investor would be up two dollars on a two dollar investment, which is 100% ($2 gain/$2 paid)....

Again this is part two of three in this trilogy. Part three coming later on today.

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