The power of options, as we know, is unrivaled by anything else in the market as they provide us the ability to limit risk and increase profits.
In fact, one of my loyal Inner Circle members went from $500 to six figures in just two years by using the pure power of options to roll over his trades from one to the next (See how he did it right here.)
Now, there’s a lot of options strategies out but one of my favorites is using the power of spread trades.
Option spreads provide us the same benefits of limited risk and explosive profits – but they also allow us to cash in regardless of what way the market moves.
And today, I’m going to tell you exactly how to implement this lucrative strategy.
Here’s exactly what you need to know…
Spreads for Reduced Risk and Quicker, Higher Probability Profits
So far, we’ve taken a look at buying calls and puts to:
- Spend Less (Leverage More Stock)
- Reduce Risk
- Increase Profits 10-Fold
Now, as great as long calls and puts are, we can further reduce cost, risk and increase the chances of profits with option spreads.
So, what’s a “spread”?
Simply put, a spread is two or more option legs placed together as a single trade.
There are numerous types of spreads we could explore including straddles, butterflies, calendars, credit spreads and condors – but we’re going to start with the simplest of the group:
Long call spreads, or as some call them, bull call spreads.
The best way to understand their power is by an example…
On 1/8/19, Netflix (NASDAQ: NFLX) came up in my scans as a 10-30 cross, signaling a bullish move.
Notice that
NFLX was trading at $320 at the time, a costly stock. Of course, buying a call option would reduce that risk.
The NFLX Feb $330 Call options cost $19.55 per share controlled which is a LOT less than $320 per share buying the stock.
That said, buying one NFLX Feb $330 call would cost $1,955, a sizeable investment for many traders.
But you wouldn’t have had to sweat that price with the power of a spread trade. This setup is able to reduce the price of the option, allowing you to get in at the right price so you can score the biggest profits.
Now, it makes sense that if we’re to reduce cost, we’ll need to sell something to bring in some cash.
And that’s where the second half of our “spread” comes in – and it comes in the form of a higher strike call option.
The NFLX Feb $340 calls were selling for $15.35 on the same date.
So, by selling the Feb $340 calls we can cut our cost by $1,535.
Here’s how the spread breaks down:
Sell NFLX Feb $340 Call -$15.35
Buy NFLX Feb $330 Call +$19.55
NFLX Feb $330-$340 Long Call Spread $ 4.20
Our Feb $330-$340 Long Call Spread gives us the opportunity to control $32,000 ($320 x 100) of stock for a $420. The cost of the spread is the maximum risk, so worst case, if the stock drops too much, the most we’d lose is $420.
Talk about a reduction in risk!
Now, let me distinguish a few things so you can embrace the power of spreads…
Buying call options gives you the RIGHT TO BUY the stock at the strike price.
Selling call options (short) gives you the OBLIGATION TO SELL the stock at the strike price.
So the rights and obligations of our spread are:
- Sell NFLX Feb $340 Call ß OBLIGATION TO SELL NFLX @ $340
- Buy NFLX Feb $330 Call ß RIGHT TO BUY NFLX @ $330
Don’t worry about the obligation to sell. The short Feb $340 call is covered by your long Feb $330 call. In other words, the obligation is covered by the rights.
If NFLX rises above $340, the worst case is that you’ll be assigned and have to sell NFLX at $340. Coupled with the right to buy NFLX at $330, this transaction would be worth $10. Subtract your net debit of $4.20, and you’re looking at a maximum profit of $5.80 per share.
Maximum profit for a long call spread is calculated as follows:
(Difference in Strike Prices – Net Debit) * 100 * Number Contracts
With a net debit of $4.20 (max risk) and a maximum profit of $5.80, we’re looking at a maximum ROI of 138%.
It’s important to note that by selling the higher strike call, we’re giving up our upside and capping the profits that would be available buying only the long call. We are sacrificing upside of a straight long call for lower risk and higher potential ROI short term.
On expiration of our long call spread (2/15/19), NFLX was trading at $356.87, well above our short $340 call.
By allowing both leg’s rights and obligations be carried out (assigned), we netted a maximum profit of $580 or 138%.
Let’s take a look at the trade would have worked out had we only bought the Feb 330 Call for $19.55 (and not sold the 340 call).
The long call would have netted us $692 (34%) profit. Although the spread netted us $580 profit, because the cost of entry was only $4.20 per share, we netted a much bigger ROI of 138% AND greatly reduced our risk.
To get you started in the world of spreads, here are some basic rules to follow.
Entry Rules
- Use spreads when cost of calls is high
- Buy lower strike call (one-two strikes out-of-the-money/OTM)
- Sell higher strike call (5-10 points higher)
- Use 30-60 day options
Exit Rules
- At expiration, if stock > higher Strike (short-call), let spread expire at maximum profit
- At expiration, if stock is between strikes, close spread
- 50% Loss
Not all of your long call spreads will end up at maximum profit as our example did. As exit rules two and three describe, you will have to close your spreads out from time-to-time.
To close a spread, simply sell the call you originally bought and buy the call you originally sold.
So, for our NFLX Feb 330-340 spread, the closing legs would be:
- Buy NFLX Feb$ 340 Call to Close
- Sell NFLX Feb $330 Call to Close
Now, long call spreads are an important part of your options arsenal and with practice you’ll master them in no time.
Once that happens, get ready for the potential gains to roll in…. just like they did for Scott C., an Inner Circle member from Grant Pass, Oregon.
Here’s what happened….
“I started with just $500 two years ago, putting all the profits into each trade thereafter…
Well, I built up my profits and seed money so high that in January, I was able to buy a brand new 2019 ZR1-EZR – a supercar with a 755hp, torque speed 215 mph. – get this – $126,995! Only 1,305 miles on it… Plus, I have money left over to continue trading.”
I don’t need to say much else. The success of my trading strategies -including using the long call spreads we just talked about – is simply unprecedented…
So if you’re ready to write your very own success story – just like Scott – click here now to learn how to take advantage.
What you do with your potential newfound wealth after that is up to you – the brand-new sports car is optional.
Tom Gentile
America’s #1 Pattern Trader
