This week's strategy was written by Kevin Ireland and was provided by the

The Options Industry Council

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Bull Call Spreads and Bull Put Spreads
© 1999 Kevin Ireland, The American Stock Exchange

Most investors are always looking for new ways to invest in the market and at the same time limit their risk exposure. With the stratospheric valuations some of the more high flying stocks are commanding, it takes an iron constitution to stay the course. The buy and hold method of investing in these type of stocks can be very profitable but leaves the investor open to an immense amount of downside risk. Someone who is not willing to accept that much uncertainty is forced to avoid these stocks and sit on the sidelines and miss the potential windfall. Using options in today's market atmosphere is a way for investors to transfer and /or reduce risk. Options investors who buy options recognize the ability to limit risk but are subjected to paying high premiums in the more volatile stocks. However, there are a wide range of option strategies that can lower those high premiums. Using these strategies provides opportunities for investors to participate in the market while limiting downside risk. Two strategies that we'll discuss are "Bull call spreads" and "Bull put spreads". They are considered conservative strategies because the risk is known and limited and are used when the investors outlook is mildly bullish. Bull spreads offer opportunities for profit if the market advances but at the same time limits the risk of a market decline.

Bull Call Spreads

A bull call spread is defined as the purchase of a call and the simultaneous sale of another call on the same underlying equity with a higher strike and the same expiration. A bull call spread is always established as a debit spread. The margin requirement is the amount paid for the spread since that is the defined and limited risk of the spread.

For example:

XYZ is currently trading at 77. The stock has risen steadily for the last six months. The investor thinks the stock can still appreciate but has significant downside risk. He decides to establish a bull call spread.

 

The above table shows the spread is effective for a neutral to mildly bullish outlook. When selling the 80 strike call to limit downside risk, the investor has also capped the upside potential. The maximum value of this spread is the difference between the two strikes or 25 points. If the investor pays 15 points for the spread then the maximum profit would be 10 points.

Why would the investor risk 15 points to make a maximum of 10? Because of the quantification of risk. If the investor had only purchased the 55 strike call at 30 , the breakeven at expiration would be XYZ at 85. Buy selling the 80 strike call at 15 you are reducing the breakeven at expiration on XYZ to 70. That means with the stock unchanged at expiration the investor still realizes a 7 point profit on a 15 point investment or a 46 % return on equity. And with the maximum gain being realized with the stock at 80 or higher at expiration, the investor only needs the stock to go up 3 points to achieve a maximum profit of 10 points or a 66 % return on equity.

To see how we can achieve these returns we need to look at time premium. If we pay 30 for the 1 year 55 strike call with the stock at 77 it has an intrinsic value of 22 points. Then we have paid a time premium of 8 points. By selling the 1 year 80 strike call at 15 that has no intrinsic value we receive a time premium of 15 points giving us a positive time premium of 7 points.

Selling more time premium than we pay out lowers the breakeven, thereby lowering the total cost of the investment or risk and lowering the strategic forecast making the best case scenario more easily achieved. Using bull call spreads in a volatile market allows the investor to utilize time premium to his advantage.

Bull Put Spreads

A bull put spread is defined as the selling of a put and the simultaneous purchase of another put on the same underlying equity with a lower strike and the same expiration. A bull put spread is always established as a credit spread. The margin requirement for a bull put spread is the amount by which the short put strike price (higher) exceeds the long put strike price (lower) less the premium received.

For example:

ABC is currently at 86 ¼ trading down 4 ¼ on the day. The investor's view is that the downside move is over and the stock should rally slightly. The annual high for the stock is 110 and the annual low is 30. The investor would like to sell a put at this level with the intention of acquiring the stock at a lower level but considers there is substantial downside risk. An alternative is to establish a bull put spread.

The above table shows the profit and loss at expiration with the stock at different intervals. Selling the higher put obligates the investor to buy the stock at the strike price if assigned. In this instance the strike is 85 and the investor takes in 16 points in premium for a cost basis if assigned of 69. The downside risk on this strategy therefore is 69 points. In order to limit that risk the investor buys the 55 strike put at 4 1/8. The risk now is the difference between the two strikes ( 30 points ) less the premium received ( 11 7/8 points ) for a total risk and margin requirement of 18 1/8 points. This is a neutral strategy with the objective being the stock remains above 85 through expiration. If that occurs both options will expire worthless and the investor will keep the 11 7/8 in premium. If the stock dips below 85 at expiration the seller will probably be assigned resulting in the investor purchasing the stock at 85 less the 11 7/8 premium for an adjusted cost basis of 73 1/8. In this instance the stock does not have to appreciate for the investor to achieve a best case scenario.

Again the investor takes advantage of selling time premium as an efficient means to effect his strategy. Using options as the tools to enact the specific strategies while at the same time quantifying and limiting risk shows the value that options can add to a portfolio. For the neutral to mildly bullish investor, bull spreads afford lower breakevens and lower risk and that's music to an investors ears.

Kevin Ireland is the Managing Director of Derivative Securities for the American Stock Exchange (AMEX) in New York. He can be reached at Kevin.Ireland@Amex.com. The AMEX web site is www.amex.com.

The statements contained in this article reflect the opinion of the author and should not be taken as statements of fact or as opinions or recommendations of Accuinvest.com.

Options involve risk and are not suitable for everyone. Prior to buying or selling an option, a person must receive a copy of Characteristics and Risks of Standardized Options. Copies of this document may be obtained from your broker or from any of the exchanges listed on our home page. A prospectus, which discusses the role of The Options Clearing Corporation, is also available without charge from to The Options Clearing Corporation, 440 S. LaSalle St., Suite 2400, Chicago, IL 60605, or from any exchange on which options are traded.