How To Use A Debit Spread Option Strategy
The Dynamic Wealth Report
August 1, 2008
Do You Buy Your Options At A Discount?
I can’t pass up a good deal. As a matter of fact, I buy the Sunday paper
every week for the coupons. I’m not afraid to admit it. I seem to have a
nose for a good deal. I can find bargains anywhere, its just as easy in
Brooks Brothers as it is the Safeway produce department.
I’ve saved a great deal of money in my life.
A few years back however, I learned a technique that’s saved me
thousands of dollars when buying options. I learned a secret way to buy
options at a discount.
I’m going to share that secret with you today.
One of the reasons I like trading options is because they’re cheap. But,
sometimes option prices are higher than I’d like. If you’ve ever traded
options you know what I’m talking about. The more volatile the stock,
the higher the option price.
In the last few months, the two hot sectors are energy and financials.
Obviously one’s been going up and the other’s been going down. As the
volatility in those industries increased the price of the options also
increased.
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Take for example Wells Fargo (WFC).
Wells has suffered the same fate as all the other banks . . . a falling
stock price. Now the big fear is the credit crisis will spread to other
areas of their business. Investors wanting to protect themselves from a
falling stock price would purchase put options.
But right now those options are expensive. Today, Wells is trading
around $30. An October $25 put would cost you a whopping $1.75 per
contract . . . or $175. Compare that with Microsoft
(MSFT) which is trading around
$25. You can buy an October $20 put (note the same amount of time and
about the same price difference of $5) and that option would cost you $0.17
. . . or $17 per contract. That’s about 10% of the price of the Wells Fargo put!
See what I mean by being expensive?
So what do we do?
We buy a debit spread. Back to the Wells Fargo example. The October $25
put options are selling for $1.75. The October $20 put options are
trading at $0.75. So buy one and sell the other. By buying the $25 put
option for $1.75 and selling at the same time the $20 put option for
$.75 you’ve cut your cash outlay by 42%.
42% is not a bad discount if you ask me.
Remember, we’re buying put options because we expecting the stock to
fall. If it goes up in price our put options expire worthless.
But if the stock moves down – Watch Out!
As the stock falls we start making money. As a matter of fact, at $24 we
break even on the trade and we make money all the way down to $20! Let’s
say the stock falls to $20. That means our put option we bought for a $1
is now worth $5. That’s a 400% gain!
Not bad for a few months work.
And if the stock keeps falling below $20, every penny made in the $25
put is offset by our sale of the $20 put. But remember, at that point
you’ve made 400% on your money. Your only loss is giving up a little bit
of additional profit.
Remember, this is an advanced option strategy. Don’t make trades like
this unless you understand all of the risks and rewards.
With that said, I’d like to hear your spread trade stories. Have a trade
go really right? Or, have a trade go horribly wrong? Drop me a note at
customerservice@hyperionfinancial.com. Your story might make it into a
future Dynamic Wealth Report article!
• First Solar (FSLR) was upgraded to “buy” by Wedbush Morgan. The
analyst gave the company a target price of $350.
• THQ (THQI) was downgraded by a number of firms including: Lazard,
Oppenheimer, and Sterne Agee. The company lowered year-end guidance.
• Collins Stewart initiated coverage on Microsoft (MSFT). The analyst
gave the company a “buy” rating. More than 20 analysts now cover the
stock. I’ll be interested to see what new insight this analyst brings.
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