The past few weeks have pretty good for the stock market, even with recession fears looming, but what will happen should the market get really spooked and sell off like we saw earlier this year? I hear this question from a subscriber email, so I decided to offer up one way to set up a bullish trade that will still profit even in a down market. A great way to take a bullish position on a stock and still have some downside protection is by using options to hedge your trade.
There are many different option strategies available, but for today’s lesson we are going to look at a bull call debit spread trade.
Here is the basic criteria you need to address when deciding to invest in this sort of bull call debit spread trades:
- You are bullish on a stock
- You want to invest in this stock, but you want to limit your risk
- You are not 100% sure that this stock will be able to maintain its current price
- If the stock does fall over the next 5 or 6 weeks, you are fairly confident the drop will be less than 10%
Question: Should I worry about hedging my investments? Why not just focus on strong investments and apply my resources betting on strong returns?
Answer: We all like to think that each trade is going to be a winner, but history has taught us that this is sadly not going to be the case. Only two things in investing that are definites… hard work and losses. Period. I don’t care how many hours you spend planning your next move and doing your homework, your next trade could be the next MCI or Enron. It happens to everyone sooner or later. Better to try to hedge at least a portion of your assets in order to protect yourself.
Ok, so assuming you have answered yes to the following questions, you may just want to look at debit spreads to get your money working on the stock, but protected against any market pull back. Let’s, for this example take a look at a stock that I currently like… Anadarko Petroleum Corp. (NYSE: APC). I like oil stocks right now, despite the recent run up, and believe that the summer driving months that are coming will only continue to prop these stocks up. But, since there has been such a run up lately, I am a bit concerned that this stock may see a slight pull back. (The perfect scenario for a bull call debit spread) .
The stock is currently trading at $64.78. You could go out and spend $6478.00 and buy yourself 100 shares of the stock and hope that you will see the price go higher. It’s possible, after-all, we do think that the price is going to go higher, but let’s assume that you want to pull in 12% on this position. That means that the stock has to rise up to $73.20. Not impossible, but you could just as easily see the stock falling 13% as well, which would lose you $842.00.
But what if I told you that you could look to profit 13% on APC, run a much lower amount of risk, and make you profit even if the stock dropped by over 10%? Would you believe me?
Well, here is how you can do just that
Debit spreads involve buying an option that is deep in-the-money while selling an option that is less in-the-money.
For this we are looking at May call options on APC. For our example we will be looking at buying May 50 calls (APC EJ) while selling May 55 calls (APC EK). By doing this trade, right now, and using 10 contracts you will have a total debit of $4,400.
Results of setting up this trade:
Capital at risk = $4,400
Target return = $600 (this is determined by subtracting the two strike prices, and then subtracting out your initial debit: in this case = 55-50-4.4 * 100o (since we have 10 contacts which represent 10o shares each) = $600
return rate = 13.6% (600/4400)
downside protection = 15.0% (amount the stock can fall and still realize your 13.6% return)
Sounds pretty nice right? Definitely. But what about the downside? First downside is that you are capping your total profit potential at 13.6%. Buying straight up stock the sky is the limit, but in this case we are limiting our potential in order to limit our risk. Downside #2 is that you could lose your total $4,400. Typically buying stock you will hardly ever see your trade reach a value of $0 (although it does happen), but with options that reality has a much greater potential.
These trades do offer exit opportunities, that you can exercise prior to expiration to limit this downside risk, and the chances of going to 0 are very slim.
Well, hopefully this gives you a bit more of an idea on how to successful use options in your portfolio. Options can be risky, so you definitely want to make sure you read over the characteristics and risks to using options before you jump into the pool.
Disclaimer : I control positions that are currently long APC.
You can read more from Michael on AOL’s Bloggingstocks
If you enjoyed this post, get all our posts with our
Email Feed!
Popularity: 2% [?]
RSS Feed
Twitter
Posted in 
Gasoline prices moved up overnight to set a 
March was another tough month for employees, as recession fears in America led to 
This morning we were seeing the markets in the red, but they were given a bit of relief following Fed Chaiman Ben Bernanke’s testimony to Congress today.
Consumer confidence has fallen to levels that we have not seen for nearly 35 years. According to the Confidence Board, 
Wall Street has been rallying today, and enjoying the strong start to the week is 
