using spreads to offset premiums – get free options!

Published on 17 Mar 2009 at 1:58 am. No Comments.
Filed under Boating,Investing.

Since October I have been attending a very expensive University. All the classes are self taught, all they provide is the classroom in the form of the stock market.  If you learn your lessons well, eventually you’ll get paid to attend. It’s kinda funny because I went through this same thing with poker. I played for at least a year as a loser, another year as a break even player and then finally one day, almost like flipping on a light switch everything I had read, learned and pondered came together and I was able to beat the game. I made a good living off of poker for a few years before black October when funding via credit cards became illegal and all the recreational money in the game dried up.

I don’t know what it is about me, maybe its just my primal fear of working a 9-5 job, but I am always drawn to these types of ways of making money, which usually involve the possibility of going home after work with less money than you went in with. The stock market has totally killed me the last 6 months. That may not be surprising to anyone with the way the market has gone, but it is my mistakes that have cost me money, not the crash of the market. In fact it was the volatility that got me into the market, seeing a possible oppotunity there.

Slowly I am learning patience, money management, risk reward strategies and ways to limit downside risk. Ironically all lessons I had to learn in poker as well. With the options premiums so high due to the volatility and fear my recent strategies have centered around using the premiums in my favor.

The trade I am most proud of recently is a spread I put on the XLF on 3/9. After the financials had been completely pounded the previous week the XLF had opened up and traded sideways most of the day. With the XLF trading at $6.30 and JPM & GS being the bulk of the index followed by WFC trading under $10 I decided to put on a bullish spread.

I bought the $9 June calls @ .41 and sold the $5 June puts @ .61.  Some might argue an $8 call would be a better bet and at that point $9 on the XLF didn’t look likely, and there’s still a good chance it won’t be there in June, but that’s what I love so much about this trade. I net .20 just for putting this trade on, taking the premium the put buyers are willing to pay out, buying a call with it, AND keeping .20 for myself. So if I buy 10 of this spread I pocket $200 while I wait, buy 20 pocket $400, etc.

A free call and money in my pocket! It sounded too good to be true and being farily new to spreads I actually mapped out my risk/reward and ran it by a friend to make sure there wasn’t anyting I was missing.

Downside Risk: XLF trades below $5 and my options are put to me. Since I got .20 premium up front my actual cost will be $4.80 and I don’t think our economy is going to 0 just yet so I have no problem owning the XLF at $4.80.

Flat: If the XLF is trading between $5 and $9 at expiration both options are worthless and I keep my .20 per contract. Still a profit on the trade.

Upside: UNLIMIMTED

So basically I got paid, yes paid (requires a margin account and naked options approval)  to put on a trade where 2/3 possible outcomes result in me making money, and one of those outcomes has an unlimited upside potential. That’s even better than getting all in on the flop with a set vs a flush draw!

Since I went out all the way to June I also provide myself more chances to get out of one or both legs of the trade. Typically buying options that far out you worry about time decay, but since I sold the put for more than the calls I bought, time decay only works in my favor.  As of today the XLF is trading at $8.12 and the June $5 put is trading at .25, a 54% profit, the June $9 call is trading at .87 a 106% profit. If I feel the recent bounce is over and the financials are in for more selloff I can cover the puts here take a 54% gain, and keep the calls on a total freeroll to see what happens between now and June. Personally I’m willing to gamble the XLF will not be trading below $5 in June so I’m keeping the whole position.

I think options are probably one of the most confusion investment vehicles for most people, I remember first learning about them and I didn’t understand the basic concept the first few times I discussed them, but now as I start to realize what they can really do I’m having a lot of fun.

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