Dawn Pennington

'Spread' Your Wings

by Dawn Pennington   09/17/08

Speculating with options can be fairly straightforward -- you buy a call option when you project that a stock is going up, or you buy a put when a stock looks like it's going to go (or keep going) down.

If you've gotten the hang of buying options, you might be looking to expand your knowledge and use of more-advanced strategies. And you don't have to be an advanced or even an active investor to add more trading tools to your arsenal.

There are two strategies that are nearly identical to buying calls and puts, but they will cost you less to initiate and they can limit your downside risk. And all it takes is one extra step to initiate these types of trades.

If you're comfortable buying a call option, you can take the next step and instead establish a bull-call spread the next time you want to use options to play a stock to the upside.

Bull-call spreads mean buying an option at a lower strike price and selling a less-expensive option against it. So, you get a credit for the short position but you still pay more for the long position.

For example, with ABC Corp. trading at $22 per share, you can buy the ABC 22.50 Calls as a bet that the stock will jump at least 50 cents during the life of your option.

But what if you're thinking that this is a stock with a lot of momentum, one that can even go to $25 while you have this trade on the table?

It's one thing to expect a stock to rise by 50 cents, but maybe a $3 jump would be challenging to achieve in an unpredictable market.

If you're convinced that the stock is going to run up and keep running, your best bet is to buy that ABC 22.50 Call and stop there. But if you're sure the stock is going to go up, but not sure by how much, you can take an extra step to buy that call for less money.

A bull-call spread is exactly what it sounds like -- a bullish bet established by buying a spread, with a spread being a two-sided trade.

The first step is to buy that ABC 22.50 Call but, in a simultaneous transaction, to sell a call against it at a higher strike price.

You can choose any strike price you want, but don't go too high because you're looking to get a credit from the option that you sell.

Before we go any further, it's helpful to know the terminology. When you purchase the ABC 22.50 Call to hold long in your trading account, you are "Buying to Open" the position. But when you sell a call against it -- say, the ABC 25 Call, you are "Selling to Open." Basically, you are "opening" two sides of a trade -- you're just buying one and selling the other at the same time.