ETF Options Strategy: Bull Call Spread - ETF News And Commentary
March 08 2013 - 6:01AM
Zacks
Despite all global headwinds the U.S. equity markets have shown
great resilience. In fact the uptrend in equities has proved that
considering the present circumstances, equities are still the best
place to park money.
Nevertheless, with the Dow surpassing its all time high and the
S&P 500 hovering around its high water mark, the question in
everyone’s mind is ‘how much more can this continue without a
pullback?’ (read Three Most Popular ETFs of February).
Some are starting to believe that a correction is imminent, or
at least overdue. But the markets have proved many pundits wrong
predicting a pullback in the recent past.
This makes a perfect case to be ‘conservatively
bullish’ on the market, especially in the near term.
Given this outlook, a Bull Call Spread options
strategy on the SPDR S&P 500 ETF (SPY) might
be worthwhile, especially given the recent pattern it has
exhibited.
As we can see from the chart above the ETF has resumed its
upward trajectory as indicated by the green parallel lines after
exhibiting some degree of distortion in the latter part of February
(red encircled portion). Furthermore it has a strong momentum of
103.62, which has been relatively flat for quite some time (read
Can the Dollar ETF (UUP) Finally Break Out?).
These factors could play an important role in the ETF sustaining
these levels with a slight bullish bias past the March expiry
series.
Strategy
One possible way to play to play these trends are with options.
A potential lower risk technique could using a bull call spread on
SPY options.
An example of this technique is as follows:
Buy: At-the-Money SPY Call option with a strike price of 155,
March 2013 expiry currently trading at $0.71.
Sell: Out-of the-money SPY Call option with a strike price of
157, March 2013 expiry currently trading at $0.13.
SPY is currently trading at $154.82 (i.e. Spot Price).
Payoff
Action
|
Type of Option
|
Strike Price
|
Premium
|
Expiry
|
Buy
|
Call
|
155.00
|
$0.71
|
March 2013
|
Sell
|
Call
|
157.00
|
$0.13
|
March 2013
|
|
|
|
|
|
Maximum Loss (Risk)
|
|
|
|
$0.57
|
Break Even Point
|
|
|
|
$155.59
|
Reward
|
|
|
|
$1.41
|
Potential ROI
|
|
|
|
238%
|
Reward: Risk Ratio
|
|
|
|
2.38
|
Payoff Explained
This is a conservative strategy in which both profit and loss is
capped. The strategy starts with a first up initial investment of
$0.57 per lot which is the difference between the option premium
paid on buying, and the option premium received on selling the
option.
This also represents the maximum possible loss that an investor
can suffer, but only if both the options expire worthless. A loss
is realized if the underlying closes below the breakeven point of
$155.59 below expiry (read Bet on the Euro with These 3 ETFs).
However, the reward for the underlying strategy could be a
handsome $1.41 which can be achieved if the underlying (i.e. SPY)
increases to $155.59 (i.e. the break even point) or more from
current levels.
Therefore we are looking at less than a one percent increase in
the underlying for a 238% return on our investment. This translates
into a Reward: Risk ratio of 2.38 times (read Two Amazing ETFs For
S&P 500 Exposure).
However, investors should note that the maximum possible gain is
limited to $1.42 per lot. Therefore even if the underlying
increased substantially more than the break even point, the profit
potential for this strategy remains the same.
Additionally, it is worth pointing out that the time until
expiration is pretty short and these contracts will need to move
favorably very soon. Thus, there is a definite possibility that
investors could see a loss with this technique.
But if you believe that the market can continue to surge higher,
and if you are seeking a lower risk short-term strategy, a closer
look at options could be the way to go for some investors.
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The ideas expressed in this article are for illustrative
purposes only.
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