How to Boost Profits Using Spread Options
Investors are always looking for a way to make their money go further. Investing in speculative high growth stocks can generate returns in excess of 100 percent or more over a couple of years. Those with an extremely high risk tolerance might play the futures market and gain leverage, as much as 200:1 in some cases, to increase returns. But there’s another way to boost returns without having to take on an exceptional level of risk.
As a general rule of thumb, one must take on more risk in order to increase possible returns. That means more volatility, more chance of under-performing other portfolios and more time spent analyzing the market and keeping track of current trends and issues. But option trading seems to be the exception to the rule. On one hand, higher risk seems obvious, but when looked at from a long-term time frame, certain option strategies can leverage your money to increase returns without having to take on exceptional risks.
Spread Options: Low Risk, High Gains
One of the biggest misconceptions investors have about options is that because they use leverage, they are inherently more risky than just investing in a stock. But in reality, there are numerous strategies that can actually reduce risk without giving up return potential. One strategy that accomplishes this goal is known as a spread option.
Spread options can be bullish or bearish, depending on which way you think a stock is going to go. Here’s how a basic bullish spread option is structured:
Let’s say you think XYZ stock is going to go higher, but you don’t want to commit a lot of money upfront in order to invest. If XYZ is trading at $50 per share, then you would need $5,000 in order to invest in it. Instead, you decide a bullish spread is the best way to go.
First, you purchase a call option at the same strike price or slightly higher than the stocks current value. Assume a 3 month call at $50 costs $500. Next, you sell a call 3 months out at a higher strike price – let’s say $60 per share. The call you sell nets you $150, making your total investment cost $350.
If the stock does nothing, the maximum amount you stand to lose is your initial investment of $350. The maximum gain happens if the stock climbs to $60 or more within 3 months. In that case, the total gain would be the difference between the strike prices – $1,000. That’s a possible profit of 285 percent on your original investment. A bear option spread works in the same manner, but with puts instead of calls.
Spread options can be a great way to act on potential opportunities without having to spend a lot of capital. The biggest downside, other than the possibility of losing your total investment, is if the stock actually does better than you expected. Taking from our original example, if the stock gains above $60 per share, that excess will essentially be lost, since you sold a call at that strike price.
If you believe a stock has a good chance of gaining quickly, it might be better to simply invest in the stock rather than use options.