Bull Spreads

09/01/00 08:48:31 AM

by David Penn

Here's an introduction to an options strategy geared toward making the most of a minor bull market.

Security: CSCO
Position: N/A

With the spring's carnage in the Internet/technology sector becoming an increasingly faint memory (depending on how you were positioned in April), traders and investors have begun talking tech again. Even Internet whipping-boy stock, Amazon.com, has come in for some good news of late, with analysts upgrading the stock in the wake of news that the world's greatest e-tailer has opened up a store in France. Still, a number of tech stocks find themselves in trading ranges, apparently unable to make major moves up or down in a stock market that has grown resistant to major moves. If you find a stock--high-tech or otherwise--that looks like it has some true upside potential, but you are afraid of a market that has not made up its mind, a bull spread may be just the option for you to consider.

A bull spread is one way that options traders take advantage of markets that are relatively bullish, but not overwhelmingly so. While there is a school of thought that suggests that traders should sit out of fickle markets, bull spreads have the advantage of limiting downside risk during an anticipated upward move and can be an effective way of exploiting a small, but clear, window of profit-making opportunity. Bull spreads involve buying a call option at one strike price and selling another call option (of the same underlying stock) for a higher strike price. The expiration dates for the options should be the same. The goal is to attempt to secure a minimum profit with the lower strike call, with some of the downside risk offset by selling the higher strike call. The bull spread, even though it has both long and short elements, is essentially a long position that limits downside risk and, to a degree, upside potential. In fact, when deployed well, the trader need risk no more than the price of the lower strike call options. If the stock doesn't reach the lower strike price before the expiration date, it certainly won't reach the higher one.

Say the price of Cisco (CSCO) is at 66 at the end of August. Your analysis suggests some limited upward potential for the stock. So you decide to make an options play instead of buying the stock outright. You purchase two Cisco October 70 calls for $2 1/2 each, and sell two Cisco October 75 calls for $1 1/8 each. Remember that each options contract represents 100 shares. In this example, the right to buy 200 shares of Cisco at 70 has been purchased and the right to buy 200 shares of Cisco at 75 has been sold. From this point, there are three possible outcomes. If Cisco does not climb above 70 by the October expiration, then you would suffer a maximum loss of $275, the cost of the October 70s less the premiums earned by the sale of the October 75s. However, if Cisco finds itself trading above 70 by the October expiration, say at 72, then you would start to realize gains.

If Cisco reached 72 by expiration, you could exercise the October 70 calls, buying 200 shares of Cisco at a $2 per share discount. Selling those shares would represent a gain of $400 (not including commissions). You also would have made out well with the October 75 calls you wrote (sold); those calls would have expired worthless. In this scenario, your net would be $400 less the difference between the cost of the October 70s ($500) and the premiums earned from the October 75s ($225) or $125. But what if Cisco made a strong bull climb, closing at 78 by the October expiration? You would still exercise your October 70s, buying 200 shares of Cisco for $70 per share. And because your October 75s would almost certainly be called should Cisco rise to 78, you could turn around and sell your 200 shares of Cisco for $75, while still keeping a $3 per share profit. After subtracting the cost of the October 75s, the gain on this trade would be $350.

It has become a trading truism that options are not for everyone. But one way that more traders can take advantage of options is by using strategies that a) limit downside risk and b) are market-compatible. Market compatible refers to the fact that a bull spread, for example, is an option strategy that takes advantage of a specific outlook on the market. Simply by electing to use call options, a trader already has made a decision (or, at the least, a hedge) on the market. Markets are always uncertain, but traders really shouldn't be--at least not at trading time. If you are thinking about using a bull spread, yet you aren't especially bullish on the market, it is probably better to stay out of the trade. A strategy that limits downside risk should not be an excuse to make halfhearted or reckless trades. But if the bull you see on the horizon is just a bit smaller than everyone else seems to think it is, a bull spread might be the way to bring the markets into sharper focus.

David Penn

Technical Writer for Technical Analysis of STOCKS & COMMODITIES magazine, Working-Money.com, and Traders.com Advantage.

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Bull Spreads

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