Options Basics Part 4

Russ Allen

Last week we looked at an opportunity in the stock of Facebook (FB). We compared buying the stock to buying call options on the stock. This is how the chart looked at that time:


A week later, on May 14, the chart appeared like this:


The stock popped on some favorable news and closed on May 14 at 81.37. That was a 3.7% increase. Meanwhile, the July 77.5 calls that we mentioned in the last article closed at $5.44, up from the $3.90 we quoted at that time. This was a 39.5% increase, or more than ten times the percentage increase in the stock itself.

Not bad so far. It looked to be a good start toward the move back to the recent highs around $86 that we thought likely. We’ll look in on this one again later.

For now, let’s look at a variation on this trade that could be even more profitable.

At the same time that the $77.50 calls were available for $3.90, there were call options at the $85.00 strike with a bid price of $1.07. These were too far above the current price of $78.43 to interest us as a buying opportunity, but instead of buying them we could have sold them at the same time that we bought the $77.50 calls. We would then be short those $85.00 calls. Selling a call option short obligates you to deliver the stock and accept the agreed-on price – in this case $85.00 – if the options are exercised by the other party. We did not expect the stock to get much higher than $85.00 by July, but if it did we would have to turn over the stock and accept $85.00 in payment.

Turn over what stock? We didn’t have any. Our only position was the $77.50 calls that we bought.

That’s fine. In any situation where we have to produce shares of stock (remember, somebody has to be willing to pay us $85.00 for that to happen), we could just exercise our own $77.50 calls and thereby buy the stock from someone else at that price. Our ownership of the $77.50 calls covers our obligation on the short $85.00 calls.

But what would be the point of selling the $85.00 calls? The point would be to collect the $1.07 per share that those calls would bring. That would reduce our net cost on the trade from $3.90 to $2.83 per share.

This type of position has a name. It is a vertical spread – one option at a strike price above another option. There are several varieties of it. In this one, the cost of the moneymaking $77.50 call is reduced by the amount received for selling the $85.00 call. If the stock does go up, the amount of profit is greater than with the long call alone in a wide price range.

Here, let’s say that the stock did go up to our $86.00 target at the July expiration. We could exercise our $77.50 calls and buy the stock at that price. Someone who had sold those $77.50 calls short would have to turn the stock over to us in exchange for our $77.50, even though the stock was much higher. That’s what they signed up for when they took our $3.90 originally.

We, in turn, would have to hand over the stock to someone who had bought the $85.00 calls from us and accept their $85.00 in payment (even though the stock was at $86.00). Net result: a gross profit of $7.50 per share ($85.00 in, $77.50 out).

From this $7.50 we have to subtract our net cost, which was $2.83 as described above. Net profit: $4.67 on a $2.83 investment, or 165%.

Free WorkshopWith the original $77.50 call only, without the short $85.00 call, our gross profit would be a little more at $8.50 ($86.00 less $77.50) but we would have to subtract the entire cost of the call at $3.90. That would leave a profit of $4.60 on a $3.90 investment, or 117%. That’s pretty darned good; but not as good as the 165% that we could make with the vertical spread.

This example highlights some of the unique features of options that make them so versatile. Tune in next time for more. Better yet, call your local center about our Professional Options Trader class.

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This newsletter is written for educational purposes only. By no means do any of its contents recommend, advocate or urge the buying, selling or holding of any financial instrument whatsoever. Trading and Investing involves high levels of risk. The author expresses personal opinions and will not assume any responsibility whatsoever for the actions of the reader. The author may or may not have positions in Financial Instruments discussed in this newsletter. Future results can be dramatically different from the opinions expressed herein. Past performance does not guarantee future results. Reprints allowed for private reading only, for all else, please obtain permission.