A ~~BULL SPREAD~~ involves the buying of a call, and selling a call in the same stock, typically for the same expiration date, and at different strike prices.
In the example of my spread, I bought the Jan 2001 $85, and sold the Jan 2001 $90. When I bought the $85, I spent $15, and when I sold the $90, I sold it for $14. That means while $15 was going out, $14 was coming in, making my net out-of-pocket just $1. I have the right to buy DELL at $85 in or before January 2001, and have sold someone the right to buy DELL from me at $90 during the same period. As long as I own the $85, the $90 is covered.
(NOTE: Your brokerage firm might give you a hard time about the technicality of whether or not the $90 is covered. Technically, it's not since you probably don't have the shares to cover it, or you don't intend to use your shares to cover. Nevertheless, you own an underlying call that acts to cover the higher strike position.)
My risk in the whole position is just $1, but for that, I have bought the spread between the $85 and $90, or $5. That spread ($5), minus my cost ($1), leaves me with a net, maximum potential return of $4 on the position.
Now you might ask, why would you do this?
The answer is that I expect DELL to be trading in excess of $90 in January 2001. I expect that my $85 will be in the money, and that the $90 will be in the money, too. The holder of the call I sold ($90) will call me, but I will call the $85 to cover. When this happens, the difference between the calls' strikes comes directly back to me (or $5 back to me).
Offset against my original cost of $1, I make $4 on that $1. (Again, this assumes that DELL is trading above $90 in January 2001. But, that's why they call it a bull spread.)
In my example, I invested $20,000 or $1 on 20,000 individual shares in leverage. Given that my leverage is 20,000 shares (200 contracts), I can make a maximum net return of $80,000 ($4 X 20,000) on a $20,000 investment.
It is also possible that DELL could finish between $85 and $90 in Jan 2001. If that is the case, the $85s have value, and the $90s are worthless, and would not be called. If DELL finishes below $85, I lose my $1 per share investment (or $20,000 in my case. I'll take that bet.)
It is important to remember that you can sell the $85 and buy the $90 back at any given time between now and January 2001, and would certainly do so (tax considerations aside) if the difference in the cost of both options grew to $5 (which it would tend to do as the price of DELL moves through $90 and upward away. That could realistically happen this Summer.)
This technique can be used in many different ways. I usually don't have the strike prices so close together (usually $10-$15 is more practical for lower leverage positions), but in this case, I could buy $5 for $1 on 20,000 shares, and it made sense.
It is really much easier to understand that you might think at first blush.
If you have a full-service broker, you can ask them to fill the order (buy the lower strike call, and sell the higher strike call) as a limit order based on the spread. In other words, instead of placing an order to buy at $15 and to sell the other at $14 (you might not fill on one side), you can say I want to do the trade for a net cost of $1 per share (or whatever you want), and make the order contingent upon that spread of only $1 being fulfilled.
If they can't do it for that, they'll let you know and you'll have to increase the spread to say $1.25 or $1.50. It's worth a try to go low first.
It's funny, on the large trades, to watch the MMs mess with the bid (on the one you're trying to buy) and ask (on the one you're trying to sell) to try to f@$& you.
Let me know if you have any questions.
Regards,
LoD |
