Stock options can induce fear in even the savviest of investors. Despite having the potential to mitigate risk and increase returns, the sheer magnitude and complexity of different strategies often force some investors astray. However, certain strategies are less imposing than they seem, and can be implemented into the common investor’s portfolio. Here are three limited-risk approaches you can execute with confidence.
An effective strategy to generate capital gains while decreasing risk, the bull-call strategy consists of two call options differing only by strike price. An investor purchases an in-the-money call while simultaneously selling an out-of-the-money call on the same underlying stock at a higher strike. Compared with a basic call, the bull-call is less expensive because it allows the investor to buy call options at a discount, as the sale of the OTM call offsets part of the premium on your long call. Though this still creates a net-debit spread, the maximum potential loss, which is the net premium paid (long call – short call), is still known from the outset. The bull-call spread, as indicated by its name, calls for a bullish outlook on the underlying as gains are realized when the stock price rises.
Zagg Inc (NASDAQ:ZAGG), known for producing protective covers for consumer electronics and hand-held devices, is an intriguing candidate for this strategy. The company recently displayed strong fourth quarter numbers, including a 30% increase in net income, outperforming Wall Street’s expectations. The company has doubled its revenue in every year since its origin, and is currently undervalued at a price of $7.44. With a trailing P/E of 9.65 and a 5 year PEG of 0.32, call me bullish.
A $7.00 call option on Zagg Inc (NASDAQ:ZAGG) with an expiration of May 13, 2013 is currently selling for $0.93. Additionally, an $8.00 call with the same terms has a premium of $0.40. Let’s say you choose to buy one hundred $7.00 call contracts and sell one hundred $8.00 call contracts. You would assume a net debit of $5,300. Now, since we are bullish on Zagg Inc (NASDAQ:ZAGG), let’s speculate and say the stock price increases to $8.50 at expiration. In this scenario, you, the investor, have a long call with an intrinsic value of $15,000, while your short call has an intrinsic value of 5,000. After deducting the initial net debit, the generated returns amount to $4,700.
Intrinsic value of long call at expiration = (100×100(8.50-7.00))= $15,000
Intrinsic value of short call at expiration (to the buyer) = (100×100(8.50-8.00))= $5,000
Profit = $15,000- ($5,000+ $5,300 (Net Debit)) = $4,700
Long Call Butterfly Spread
This direction-neutral strategy profits from low volatility – more specifically, when the price of the underlying stock remains relatively unchanged at the option expiration date (all options used should have the same expiration). To perform a long call butterfly, the investor purchases one ITM call with a low exercise price as well as an OTM call with a high strike. Additionally, two at-the-money call option contracts must be written by the investor. Similar to the bull-call spread, the price of the bought options outweigh the price of the sold options, creating a net-debit to the investor’s account; the maximum loss that can be incurred from this strategy is the net premium paid. As previously indicated, the profitability of this strategy depends largely on implied volatility. The lower the VIX, the more enticing this strategy becomes. Long calls cheapen, limiting downside, and the probability of the underlying fluctuating decreases. Even when uncertainty is high, the long call butterfly can still be beneficial if used with stable, mature companies experiencing constant growth.
One of the largest providers of electrical services in the United States, The Southern Company (NYSE:SO), has been an energy powerhouse since the beginning of the 20th century. With stable growth rates and consistent delivery of dividend payouts to investors, Southern Company is a fantastic low-volatility investment. It is presently among the top holdings of the PowerShares S&P 500 Low Volatility Portfolio.
The company’s stock price currently sits at $45.01. We can purchase one hundred $43 calls for $22,800 and one hundred $47 calls for $1,700 (Expiration- May 13, 2013). By then selling two hundred $45 call option contracts for $15,600, we execute a long call butterfly. Though we are instantly at an $8,900 net debit and stand to lose it all if the stock price comes too close to the wings of our spread, we will profit if our underlying holds fairly constant. For the sake of this example, let’s say the price of SO at expiration is $44.75. The situation would unfold as follows:
Intrinsic value of $43.00 long call = ((44.75-43.00) x (100×100)) = $17,500
Intrinsic value of $45.00 short call = $0
Intrinsic value of $47.00 long call = $0
Profit = $17,500 – $8,900 (initial net debit) = $8,600
Long Straddle Spread
With uncapped profit potential and limited liability, the long straddle spread should attract all investors. Very simply, an investor achieves the long straddle by buying a call and a put with the same expiration and exercise price. This puts the investor in position to capitalize regardless of which direction underlying shifts. The greater the swing in price, the higher the gains realized. Thus, when a company’s outlook is extremely uncertain, the long straddle can be effective. It is best used with a company still in its growth stage, or one about to release a highly-promoted new product. As with the previous two strategies, the investor recognizes the maximum potential loss (premiums paid) from the beginning, which occurs when the underlying remains constant through expiration.
Questcor Pharmaceuticals Inc (NASDAQ:QCOR) is a small cap biopharmaceutical company that demonstrates strong growth potential. The company recently reported that its net income nearly doubled in the fourth quarter. Bullish earnings such as these could set the stock on an upwards track. Biotech stocks are hardly ever a sure thing though, and Questcor Pharmaceuticals Inc (NASDAQ:QCOR) is no exception. A large percentage of the company’s sales derive from its drugs that treat multiple sclerosis. Increased competition or any seemingly minor production setbacks could create a world of trouble for QuestCor. As it is, the company’s historical prices reveal extreme volatility over the past year. Not too worry though, this only enhances the stock’s suitability for a long straddle spread.
A share of QCOR currently sells for $32.60. If we buy one hundred $32 call option contracts for $43,000 and one hundred $32 put option contracts for $45,200 (Expiration- July 13, 2013), we form a long straddle. Notice that the high implied volatility of the stock leads to higher premiums on option contracts. Let’s take a ‘glass half-full’ approach and assume the price soars to $45.00.
Intrinsic value of call = (($45,000-$32,000) x (100×100)) = $130,000
Intrinsic value of put = $0
Profit = $130,000 – ($43,000 + $45,200) = $41,800
Even if the stock tanks, we can be equally profitable. Assume the price drops to $18.75. While the call is then worthless, the put now has an intrinsic value of $132,500 (13.25 x 10,000) and we make a profit of $44,300.
Constructing option portfolios enable investors to profit from anticipated price changes in underlying securities and hedge risk associated with unforeseen changes. Ultimately, options limit financial exposure and potential loss linked to uncertainty. When the expected volatility of a stock in a given time frame is correctly forecasted, investors can realize large gains and increase their general wealth. The above strategies provide a solid foundation for option trading. Once properly understood, they can be immediately effective in controlling risk and delivering an all but guaranteed return.
The article Expand Your Investing Horizons With These Three Options Strategies originally appeared on Fool.com and is written by Brett Lonergan.
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