Options Vertical Call Spread
If you think the gold market is going up and you want to be a buyer, you could buy the gold futures contract and for every $1 that gold goes up you make $100, and every $1 down you lose $100.( gold futures contracts are 100 ounces $1 X 100 ounces = $100).
Buying options allows you to KNOW your total risk if wrong and what you can make if you are right. One of the advantages of buying an option is that you can stay in your position in a choppy market and not get shaken out.
Settlement Friday 10/13/06 Feb07 gold was $598.60, the 600call $2400, 660call $720.
This spread involves the buying of one strike price and selling another. For an example we will look at the gold market on the COMEX exchange. Feb07 gold settled Friday 10/13/06 at $598.60, the Feb.07 600call settled at $2400, and the 660call settled at $720. This means if you buy this vertical call spread you have the right to be long Feb07 gold from the price of 600, at a cost of $2400 and at the same time you sell the right to someone else to be long from 660 for $720. $2400-$720= $1680, instead of $2400, for the right to be long Feb07 gold from 600, because you give up the right above 660. The most you can collect is $6000 (600 to 660) and you paid $1680, the most you can make is $4320 minus commissions. A 250% gain. If you bought the 600 call outright it would need the futures to go to $624.00 by expiration to be even, above for unlimited profit. If you bought the spread instead, it would cost $1680, and at $624.00 you would profit by $720. There are other pros, cons, and trade offs involving options.
NOW COMPARE EVENLY $ FOR $
If you bought 2 600 calls you pay $4800, but you could buy 3 spreads instead for $5040 and have the right to be long 3 contracts instead of 2 from 600. If the futures price at expiration is $660, you would make $12,960 on the spreads and only $7200 on the 2 outright calls. The 2 calls would need for the Feb07 futures to go to $688.80 to make the same and above to make more than the spreads.
I hope you can start to see how the market does not need to go as high to make more on this spread then the calls (naked call) or futures contract. Also you are selling a wasting asset against the one you buy, which will pay for some time decay. (In time your option is worth less because there is less time for it to work, meaning you pay a premium for the time left until it expires.) You collect $720 for selling the right to be long at 660 which is worthless unless the 600 call is worth $6000.
Unless you think that gold is going much higher than $688.80 (same profit as spreads will make at 660) by Feb 07 option expiration (1/25/07), then this is the spread to use for the best risk/reward. You can use different strikes and option expiration date, based on your own thoughts and find your best strategy using the simple math I have shown in my example. You can customize your strategy to reflect what you think and make the most of the risk/reward to give you a big edge in your trading.
After the spread is on, you can always add or take off some of your position to reflect any change to what you think about the market including buying back the 660 call and then being outright long the 600call (very bullish).
MAKE IT A LEARNING EXPERIENCE
If you watch and write down the settlements of all three everyday or at least every Friday until expiration, and you will observe many things about options such as time decay and how options perform when the price goes up or down..
You must have a plan. You must have a proper risk/reward by not risking $300 to make $100. It must be the other way, making $300 and risking only $100. Last but not least, you must have money management!
Consider learning and trading options and I will try and make it easier for you.
May Your Next Trade Be Your Best, Copyrighted 10/16/2006
Howard Tyllas
Futures’ trading involves the substantial risk of loss and may not be suitable for all investors. Past performance does not mean future results. |
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