Last time we looked at buying an ITM call
option. (Jul 19, 2010)
One of the best characteristics of options is the ability to use them
to reduce risk. That involves a technique known as hedging.
Hedging is just the process of using one investment
to offset, or partially offset, the risk of owning another investment.
NOTE: As a general rule, I am opposed to the purchase of call and put
options as speculative plays. The reason is that most traders go about
the process incorrectly. They buy positions with little chance of
being profitable.
When you, as an investment club, buy a call option, potential profit
may be unlimited, but in practice, gigantic profits are extremely
rare. The goal is to take a more conservative approach. That is
accomplished by buying options that are already in the money (ITM). I
discussed this is greater detail: Jun 9, 11, 2010.
Today the topic reducing the risk even further by hedging the option
purchased. That is accomplished by selling another call option. The
option chosen has a higher strike price than the option you own. It
also has a smaller cash premium. As a result, you must pay something
to own the position (it's referred to as a 'call spread'). The good
news is that your total investment costs less. The less good news is
that in return for reducing risk, potential profits are limited.
Investment clubs, as well as individual traders, would be well advised
to avoid on greed and count on earning money on a consistent basis.
Spreads help the investor do just that.
Example
ABCD is trading at $42 and you want to make a
short-term investment in this company*
*I get it. Investment clubs looks for longer-term investments. You
can use options for those plans, but we are in the stages of learning
about options, not in making specific investment decisions.
Buy ABCD Nov 40 call. Cost $420
Sell ABCD Nov 45 call. Collect $160.
Net cost (net debit): $260.
What do you own? You bought the ABCD Nov 40/45 call spread and
invested $260. That is significantly less than the Nov 40 call costs.
Thus, your worst case scenario, and maximum loss, is $260.
This is a bullish position. You can earn the maximum profit ($240) if
ABCD is above $45 per share when the options expire at the close of
trading on the 3rd Friday in November.
to be continued...
Mark D Wolfinger
To read more of my blog posts, visit Options for Rookies
Expiring Monthly: The Option Traders Journal
http://www.expiringmonthly.com/
