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Wednesday, May 27, 2009

Option Spreads With Greater than 40% Chance of Doubling Your Investment

In this post I will talk about some option plays I have been / will be using to capture a potential large upside with a limited downside. I’ve been very bullish on commodities lately which will explain some of the equities I've used early in this article.

In this post I'll be talking about Bull Call Option Spreads, to understand this you must be familiar with stock options. To learn more about stock options check out my option E-Book.

All of the strategies used in this article are currently priced with the higher end of the option spread having a greater than or equal to 40% chance of expiring in the money, and having the potential of returning at least double your initial investment if they hit and close above the higher strike price of the spread (according to options pricing as of pre-market Wednesday May 27).

Spread Strategy # 1: Buy the SPDR GOLD Trust (GLD) July $94 Call and sell the July $96 Call. The $96 call option is factoring in a 42.9% chance it will expire at or above it at July expiration. If it happens to expire at or above $96 return would be 150%. Similar strategies can be used for GOLD, UGL, GG, GSG, and other gold and mining equities.

Spread Strategy # 2: Buy the United States Oil Fund (USO) June $34 Call and sell the June $35 Call. The $35 call option is factoring in a 41.4% chance it will expire at or above it at June expiration and would return 122% if it did. Similar strategies can be used for UCO, XLE, UNG, DIG, XOM, and other oil and gas equities.

Spread Strategy # 3: Buy Apple (AAPL) July $130 Call and sell the July $135 Call. The $135 call option is factoring in a 44.9% chance it will expire at or above it at July expiration. If it happens to expire at or above $135 return would be 108%. Similar strategies can be used within the tech sector on stocks such as RIMM, PALM, AMZN, EBAY, GOOG, YHOO, MSFT, and many more.

Spread Strategy # 4: Buy SPDR S&P Depository Receipt (SPY) July $92 Call and sell the July $93 Call. The $93 call option is factoring in a 43.4% chance it will expire at or above it at July expiration, and would return 108% if it did. Similar strategies can be used for the DIA and the QQQQ. If you want to take on more risk with a greater potential reward you could also use a similar strategy with the leveraged ETFs such as SSO, BGU and many more.

Spread Strategy # 5: Buy the Financial Select Sector SPDR Fund (XLF) September $12 Call and sell the September $13 Call. The $13 call option is factoring in a 43.8% chance it will expire at or above it at July expiration. If it happens to expire at or above $13 return would be 122%. Similar strategies can be used for other sector ETFs such as XLP, XLU, XLY, XLV, and XLK, as well as individual financials such as AXP, BAC, BK, C, GS, JPM, and many more. If you want to take on more risk with a greater potential reward you could also use a similar strategy with the sector leveraged ETFs such as UYG, FAS, UYM, and many more.

All option spreads must close at or above higher end of the spread at expiration to receive the maximum profit from the strategy. It is possible to lose 100% of your investment if the underlying equity closes below the lower end of the spread. These spreads can be traded which I find works well in this volatile market.

With many stocks it is possible to find a strategy that offers a 40% chance of expiring at or above that returns 100% profits. The odds are still not in your favor, but it is a way to capture a large upside with minimal downside. By choosing different strike prices and expiration dates you can adjust the chances of expiring in the money, and the profitability from the spread. I use the 40% 100% rule as I never have to go out too much further than 3 months- keep in mind a lot can change with options pricing overnight.

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2 comments:

Harry said...

Would you please tell me what u used to calcuate the chance of option being expire in the money (at or above the higher strike price)? Thanks a lot,

Marco H said...

Harry, I use the Black Scholes model to calculate option probabilities. Most brokerages have option calculators on their sites and will give you the calculated values.

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