  1: Legging into a Spread If you recall, a spread is using a long option to cover the risk of a short one. It is a directional play - a play in which you are betting on the direction of a stock. Spreads can be made using either calls or puts, and you can either be bullish or bearish on the underlying security. Spreads can be entered into one of two ways: the short option can be sold at the same time as the long one is purchased, or you can "leg into" the trade by purchasing the long one first, and then waiting until the stock moves a bit in your favor before selling the short one. Legging into the trade is tricky. Obviously, your first few trades should all be made all at once until you feel comfortable with spreads. But when you're ready to try to pull out a bit more profit from a trade for less money at risk, legging into spreads is one way to do that. An example: Our friend Doug is bullish on Wal-Mart. It is currently $52 a share, and he thinks it will go to $60. Scenario A: If he simply purchases the stock, it will cost him $5,200 for 100 shares, and if it goes to $60 he will make $800 in profit or 15.4%. Scenario B: He could also buy a call option on the stock. It will cost him $6.75 for the JAN'01 $50 CALLs, or $675. At $60 a share, his profit will be $3.25 a share ($60 - $50 - $6.75) or $325. That's a 48% return. Scenario C: He could put a Bull Call Spread on the stock. He buys the JAN'01 $50 CALL but he sells the JAN'01 $60 CALL for a net cost of $4.25 a share or $425. If the stock goes to $60 his profit is $5.75 ($60 - $50 - $4.25) or $575. That's a return of 135% - a return to be proud of! Scenario D: Lastly, he could place the Bull Call Spread, but leg into the trade instead. First he buys the JAN'01 $50 CALL for $6.75 a share or $675. He waits a couple of weeks, and in the meantime Wal-Mart stock has risen from $52 to $55. At this point, instead of getting $2.50 for the JAN'01 $60 CALL like he would have two weeks earlier, he gets $4.00 for that call. Because he legged into the spread, it only cost him $2.75 a share or $275. He makes $7.25 profit ($60 - $50 - $2.75) for a return on investment of 263%. Legging into the spread allowed him to save a lot of money on the cost of the spread. So the moral of the story is that legging into spreads can be tricky. You have to watch the stock and wait for the optimal time to open the second leg of the trade. But if you do it right it can take most if not all of the risk out of a trade, while allowing you to keep more of the profits! ©2001 xguru, Inc. A Cardinal Factor Company. All rights reserved. |
