How to Profit if a Stock Goes Up or Down

By: Chuck Hughes

The following is an excerpt of Chuck Hughes’ Market Volatility Profit Secrets

The option spread strategy presented in this article has one of the best overall risk/reward profiles of any of the strategies I trade.  When you buy an out-of-the-money call option the premium consists of only time value and the price of the underlying stock has to rise considerably (depending on the strike price of the call) in order to break even on the trade.  This is a result of the time decay characteristics of options as they approach expiration.  Options lose all time value at option expiration.  For example, today is August 20th and Apple stock is currently trading at 123.22.  The Apple September 140-Strike call option s trading at 2.35 points and expires in about 5 weeks.

Buy Apple 140-Strike call option at 2.35 points

140.00 Strike
 +2.35 Premium
= 142.35 Breakeven

Apple stock has to trade up to 142.35 at option expiration which is a 13.6% price increase before you break-even on this trade.  If Apple does not close above 142.35 at option expiration then a total loss of the option premium will be realized making this purchase of an out-of-the-money call option a high risk investment.  In-the-money call options have less time value than out-of-the-money calls.  Purchasing an in-the-money option requires a much lower price increase in the underlying stock to break-even compared to an out-of-the-money call and therefore the in-the-money call has a greater chance of being profitable and carries less risk.

There is a way to dramatically improve the risk/reward profile for option-investing beyond purchasing in-the-money options.  Option spreads completely change the risk/reward profile of option investing.  Instead of purchasing an Apple call option today, let's look at establishing an option spread using Apple call options.  Today is August 20th and the Apple January 11-Strike call option is currently trading at 22.10 points and the January 120-Strike call is trading at 16.90.  A call option spread can be created by buying the 110-Strike call and selling the 120-Strike call.

When you create an option spread by purchasing a call option and selling a related call option with a higher strike price:

*  The call option purchased profits if the price of the underlying stock increases
*  The call option sold profits if the price of the underlying stock decreases
*  Your risk is limited to the cost of the spread

The table below displays the risk/reward profile for buying the Apple 110-Strike call option for 22.10 points and selling the Apple January 120-Strike call for 16.90 points.  The table displays profit results for various price changes for Apple stock at option expiration from a 15% increase to a 5% decline.  Apple stock is trading at 123.22.  If Apple stock increases 2.5% at option expiration to 126.30 a 92.3% return will be realized (circled).

Apple Option Spread Analysis
Buy 110-Strike Call Option @ 22.10
Sell 120-Strike Call Option @ 16.90
  Cost      5.20

The cost of this spread is $520 and is calculated by subtracting the 16.90 points we received from the sale of the 120-strike call from the 22.10 cost of the 110-strike call we purchased.  The most we could lose on this spread trade is the $520 cost of the spread.

Let's take a look at how a 2-1/2 percent increase in Apple stock to 126.30 results in a 92% return for this spread trade.  If Apple stock is trading at 126.30 at option expiration, the option we purchased would lose value but the option we sold would increase in value and our spread would have a 10 point value.  A 10 point spread value would result in a 4.80 point profit or $480 from our $520 purchase price.  With a $520 cost, a $480 profit represents a 92% return.  So in this example the option we purchased would realize a loss but the sale of the 120-strike call option allows us to make an overall profit on the spread trade.

If Apple stock remains flat at 123.22 at option expiration then a 92% return will be realized (circled).  Again this is possible due to the profit on the sale of the 120-Strike call option.

Apple Stock Flat = 92.3% Return For Spread

And if Apple stock declines 5% to 117.06 a 35% return will be realized (circled).  Profiting on a call option trade when the underlying stock declines in price is only possible because of the sale of the 120-strike call.  This spread trade can be closed out anytime prior to option expiration by selling the 110-strike call and buying back to close the 120-strike call.   I will normally close out and take profits on a spread if the spread reaches 90 to 95% of its profit potential.

Apple Stock Declines 5% = 35.7% Return For Spread