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An Enormously Profitable Options Strategy, Part 2By Jeff ClarkThursday, July 5, 2007 You have to love perfect timing.
There's nothing more exciting to a trader than buying a stock or an option and watching it immediately explode higher.
On Monday, I wrote about how airline stocks, and AMR in particular, were starting to look pretty good. That afternoon, I told S&A Short Report subscribers about an option strategy on AMR that offered a rare combination of low risk and high reward. Then on Tuesday, the airline stocks, and AMR in particular, took off.
AMR jumped almost 5% on Tuesday, and the option position we bought during the final hours of trading on Monday gained more than 25%. Like I said, you have to love perfect timing.
But you're nuts to bet on it.
Most traders will tell you that it's rare for a trade to move in your direction right after you set it up. Most times, in fact, trades immediately go the other way. It's a kind of "Murphy's Law" for traders.
So when you're setting up a trading strategy, you have to allow some time for it to work out. But when you're trading options, time works against you. As I wrote on Monday, it's like stepping into the batter's box with the count already one strike against you.
And buying expensive options is like being two strikes down.
Spreads can help you even the count. A spread is the simultaneous purchase of one option and sale of another. The idea is that the premium received from the sale helps pay for the premium on the purchase.
For example, on Monday morning, AMR was at $26.30 per share... and the AMR August 27.50 calls were trading for $1.40. That's an expensive option. AMR would have to rally to $28.90 ($27.50 stock price plus $1.40 premium), or 10%, for the option buyer just to break even (granted, Tuesday's 5% gain goes a long way toward solving that problem).
And in order to get a double on the trade, the option buyer would need the stock to hit at least $30.30. That's a lot to ask for in just seven weeks.
Creating a spread by selling the August 30 calls, which were trading for about $0.50, helps to offset some of the cost.
Here's what one spread might look like: Buy the AMR August 27.50 call for $1.40, and sell the AMR August 30 call for $0.50.
The net cost of this trade is just $0.90 ($1.40 minus $0.50). We lower our breakeven point to $28.40. And we'll score a double if AMR can rally to $29.30.
So we have less money at risk. We have a lower breakeven point. And we have a much higher probability of success on this trade.
Of course, if your timing is perfect, then you can go ahead and buy expensive options.
But for the rest of us mere mortals, spreads are a terrific way to put the count back in our favor.
Best regards and good trading,
Jeff Clark
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