I got burned by options a couple years ago, and have stayed away ever since. But in the last few days, I’ve been learning how to manage risk using options, especially by using spreads. I decided to try out some spreads today in my optionshouse practice account.
WARNING: If you are not familiar with options, the next part is going to be gibberish. Use Google to find a good resource on educating yourself about options if you are at all interested, and please use a virtual account to try it out before putting real money in the market. Cheers.
2 of them are Bull Call Spreads, which means buying a call option on a security at a realistic strike price out-of-the-money, and at the same time selling a higher-priced out-of-the-money call. What ends up happening is pretty awesome – a lot of the cost is cancelled out since you’re buying and selling a contract, but not all of it since you’re buying the less risky option. If the security goes down in value, you and the person you sold to lose, but your losses are less than they would be just buying a call. On the other hand, if the security rises in value, which one who enters this spread assumes will happen, but not enough to bring the sold option into the money by the expiration date, you keep your profits. The best part is that even if the sold option goes into the money, it doesn’t really matter as long as you keep your call around as long as they do. If they exercise early, all the better, as you can take your profit in safety.
The other spread I’m trying is an Iron Condor. To explain this, you need to understand what a Bear Call Spread is and what a Bull Put Spread is. I’ve linked both of these, so I suggest you read them, especially the examples (that’s how I learn). Now that you know that, imagine combining them. This is what’s known as an Iron Condor. Basically, instead of being bullish or bearish on a security, you are banking on it staying in some range. You can manipulate this range using the strike prices of the options you buy and write.
Here’s a graph from my new favorite discount broker, Zecco:
What’s happening here is an Iron Condor (slightly modified for an upside move). Maximum profit is obtained from the 104-112 range. If the final price falls much outside this range, you’re going to incur a loss. It’s best to do this on stocks that have very little volatility – like indexes.
We’ll see how this goes virtually, and consider trading it a bit in real life, just for kicks.