Why Profit with Options Spreads?
Plus, a look at potential trades using this strategy with META and QQQ.
This service is for general informational and educational purposes only and is not intended to constitute legal, tax, accounting or investment advice. These are my opinions and observations only. I am not a financial advisor.
How many times has this happened to you?
After reviewing name after name you find a stock setting up for a nice trade and options seem like the right strategy. But you run into a problem.
The prices of the options appear too expensive to make a trade work. No matter which option you look at the price is just too high to make sense, so you pass on the opportunity.
Or worse, you slide down the options chain to find an option that appears “cheaper” or “cheap enough” to attempt a trade with. These are typically well out of the money and do not offer a great risk to reward ratio and really aren’t the trade you wanted.
What usually follows is regret. Either from missing out on the trade entirely or choosing the wrong option and missing out on the profits.
You can stop the madness and the mistakes by adding options spread strategies to your trading menu. And they really are simple.
It is understandable if you have avoided trying to use spreads because they can seem complex or even intimidating but I’ll show you why you can stop looking the other way.
First, what is an option spread?
The easiest example to utilize is the vertical option spread which involves options that expire on the same day but have different strike prices.
A vertical call option requires buying a call at one strike price while selling a call at a higher strike price. You want to buy and sell an equal amount of calls and use the same expiration date.
I like real life examples so here’s a look at META.
With this example, the cost of the option spread is $4.95 and has room to increase in value to $15.00 if META shares run all the way to $290 per share or higher by June 23rd.
Why not just buy the single call option? Why bother with a spread?
Frankly, it is a better strategy for managing risk. It also can allow for bigger gains than simply just buying options, which surprises most people.
With this example, the difference could mean increasing gains from 111% with a single call option to 203% utilizing a vertical call spread.
Quick Plug
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Ok back to options spreads, how they work, and two trades you can consider in the coming weeks.
How Does it All Work?
Let’s start by looking at the chart for META, specifically the hourly candles for META. Continuing to climb higher, there is a trade to the upside which is why I like considering the $275-$290 call spread.
And why those strike prices?
First, I like buying the at-the-money (ATM) call options or just slightly out-of-the-money (OTM) call options and the shares of META closed just below $273.
Next, you can see the levels drawn on the chart. The $289.01 level happens to be the top of a gap that formed in January 2022 for META shares.
I like the gap to fill followed by a pause or slight rejection which is typical after shares retrace and close gaps in charts. This is why I’ve drawn the resistance level here.
The strike price for the call option being sold should be at or near a resistance level that is being targeted, in this example it is 289.01 above. This is because we would expect the shares to slow down or even reject at this price level.
The gap isn’t shown but the chart below highlights the levels targeted for taking profits when trading META.
Choosing the expiration date is a little more subjective. Take a look at how quickly the price moves and how long you expect it to take to reach the target prices.
Also pay attention to any key dates coming up, such as reporting earnings. These events can have a significant impact on options prices.
I chose the June 23rd expiration date beacuse while I think this move could take place in just one or two weeks, I prefer to give myself a little extra time to help manage risk.
The bullish vertical call option spread in this example is really just a fancy group of words that mean you bought a call option and then recouped some of your money by selling another call option that is further out of the money.
You’ve made your cost of trading less. You’ve defined your risk. And you know exactly where your maximum profit level is. This is what trading options spreads is all about.
Call Options vs Call Options Spreads
While it is true that just buying a call option allows for potentially greater gains if the stock really takes off, it is really less likely to happen.
What is more likely is that the stock falls into any one of the following scenarios which all have better outcomes with options spreads: the stock drops, the stock stays flat, the stock moves up modestly, the stock moves up as expected.
There are four scenarios where the options spread works best and one scenario, which is also the least likely, where buying a call option alone is best.
Let’s take a look at each one.
First, the stock could drop in which case both strategies go to zero but you would lose less ($4.95 vs $7.10) with the spread strategy.
Next, the option could remain flat and again both strategies go to zero but again the spread loses less.
If META moves up but only modestly, and at expiration the shares only manage to get to the first level of resistance of 278.89 or just above to 280, the spread strategy wins again.
The call option alone would be worth $5.00 ($280 share price - $275 strike price) and would be a loss of $2.10.
The spread option in this same example would have a very small gain, but a gain and not a loss. The value would be worth the same $5.00 but the original cost was only $4.95.
If META makes the move we are looking for and reaches the $290 price level by the expiration date they would each be worth $15.00.
For the call option alone that is a 111% gain ($7.10 to $15.00) where the spread contract would have increased by 203% ($4.95 to $15.00), more than tripled.
The call option alone would move up more if the price moved up quickly before the expiration date or if it moves beyond the resistance near $290, but you are now asking for more from the trade than you need to with a spread.
To recap,
Options Spreads allow you to do a better job of managing risk than buying options alone.
Options Spreads provide better outcomes across more scenarios when compared with buying options alone.
Options Spreads have the same if not more flexibility than trading single options.
I hope this illustrates why I believe this is such a great strategy and why you’ll see me post ideas that use spreads from time to time.
Hedging with Options Spreads
You might want to offset downside risk after a big move up by using put options but feel that the put options are just too expensive.
This is where options spreads can be a huge benefit as well.
The QQQ ETF has been enjoying a huge run to the upside and many are saying it is overextended and due to pull back some.
You could buy ATM puts which are the $355 strike, expiring June 23rd for $5.82 as of Friday’s close.
This means the shares would need to drop to $349 before these put options start paying off.
Now consider using a put spread, buying the same $355 strike put but selling the $340 strike put for $1.33, dropping the overall cost of trading from $5.82 to $4.49.
This means the put spread starts paying off when shares hit $350.50, providing that much more protection.
Setting the strike prices is the same idea as when buying a vertical call option spread but you are looking for areas of support below to target.
You can hedge with less of a hit to the account or short with better probability of profiting by using a put option spread strategy.
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Thank you again for reading and have a great week!
Nate